UNIT -3

Introduction to Options, Hedging with

Currency Options
• An option is a financial contract that gives an investor the right, but not
the obligation, to either buy or sell an asset at a pre-determined price
(known as the strike price) by a specified date (known as the expiration
date).
• Options are derivative instruments, meaning that their prices are
derived from the price of their underlying security, which could be
almost anything: stocks, bonds, currencies, indexes, commodities, etc. 
Many options are created in a standardized form and traded on an
options exchange like the Chicago Board Options Exchange (CBOE),
although it is possible for the two parties to an options contract to agree
to create options with completely customized terms.
• There are two types of options: call options and put options. A buyer of
a call option has the right to buy the underlying asset for a certain price.
The buyer of a put option has the right to sell the underlying asset for a
certain price.
 Introduction to Options, Hedging with
Currency Options
• An option is a financial contract that gives an investor the right, but not
the obligation, to either buy or sell an asset at a pre-determined price
(known as the strike price) by a specified date (known as the expiration
date).
• Options are derivative instruments, meaning that their prices are
derived from the price of their underlying security, which could be
almost anything: stocks, bonds, currencies, indexes, commodities, etc. 
Many options are created in a standardized form and traded on an
options exchange like the Chicago Board Options Exchange (CBOE),
although it is possible for the two parties to an options contract to agree
to create options with completely customized terms.
• There are two types of options: call options and put options. A buyer of
a call option has the right to buy the underlying asset for a certain price.
The buyer of a put option has the right to sell the underlying asset for a
certain price.
 Hedging with Currency Options
• Currency options are useful for all those who are the players
or the users of the foreign currency. This is particularly useful
for those who want to gain if the exchange rate improves but
simultaneously want a protection it the exchange rate
deteriorate. The most the holder of an option can lose is the
premium he paid for it. Naturally, the option writer faces the
mirror image of the holder’s picture: if you sell an option, the
most you can get is the premium if the option dies for lack of
exercise. The writer of a call option can face a substantial loss
if the option is exercised: he is forced to deliver a currency-
futures contract at a below-market price. If he wrote a put
option and the put is exercised, then he is obliged to buy the
currency at an above-market price.
 Speculation and Arbitrage with Options,
Pricing Options
• Arbitrage and speculation are two very different financial strategies,
with differing degrees of risk.
• Arbitrage involves the simultaneous buying and selling of an asset in
order to profit from small differences in price. Often, arbitrageurs buy
stock on one market (for example, a financial market in the United
States like the New York Stock Exchange) while simultaneously selling
the same stock on a different market (such as the London Stock
Exchange). In the United States, the stock would be traded in U.S.
dollars, while in London, the stock would be traded in pounds.
• As each market for the same stock moves, market inefficiencies, pricing
mismatches, and even dollar/pound exchange rates can affect the prices
temporarily. Arbitrage is not limited to identical instruments;
arbitrageurs can also take advantage of predictable relationships
between similar financial instruments, such as gold futures and the
underlying price of physical gold.
 Pricing Options
• Option pricing refers to the amount per share at which an option is traded. Options
are derivative contracts that give the holder (the “buyer”) the right, but not the
obligation, to buy or sell the underlying instrument at an agreed-upon price on or
before a specified future date. Although the holder of the option is not obligated to
exercise the option, the option writer (the “seller”) has an obligation to buy or sell
the underlying instrument if the option is exercised.
• Depending on the strategy, options trading can provide a variety of benefits, including
the security of limited risk and the advantage of leverage. Another benefit is that
options can protect or enhance your portfolio in rising, falling and neutral markets.
Regardless of why you trade options – or the strategy you use – it’s important to
understand how options are priced. In this tutorial, we’ll take a look at various factors
that influence options pricing, as well as several popular options-pricing models that
are used to determine the theoretical value of options.
• The value of equity options is derived from the value of their underlying securities,
and the market price for options will rise or decline based on the related securities’
performance. There are a number of elements to consider with options.
 Pricing Options
• In-the-money: An in-the-money Call option strike price is below the actual stock
price. Example: An investor purchases a Call option at the $95 strike price for
WXYZ that is currently trading at $100. The investor’s position is in the money by
$5. The Call option gives the investor the right to buy the equity at $95. An in-the-
money Put option strike price is above the actual stock price. Example: An
investor purchases a Put option at the $110 strike price for WXYZ that is currently
trading at $100. This investor position is In-the-money by $10. The Put option
gives the investor the right to sell the equity at $110
• At the money: For both Put and Call options, the strike and the actual stock prices
are the same.
• Out-of-the-money: An out-of-the-money Call option strike price is above the
actual stock price. Example: An investor purchases an out-of-the-money Call
option at the strike price of $120 of ABCD that is currently trading at $105. This
investor’s position is out-of-the-money by $15. An out-of-the-money Put option
strike price is below the actual stock price. Example: An investor purchases an out-
of-the-money Put option at the strike price of $90 of ABCD that is currently
trading at $105. This investor’s position is out of the money by $15.
 Pricing Options
• The Premium
• The premium is the price a buyer pays the seller for an option.
The premium is paid up front at purchase and is not refundable – even if the
option is not exercised. Premiums are quoted on a per-share basis. Thus, a
premium of $0.21 represents a premium payment of $21.00 per option
contract ($0.21 x 100 shares). The amount of the premium is determined by
several factors – the underlying stock price in relation to the strike price
(intrinsic value), the length of time until the option expires (time value) and
how much the price fluctuates (volatility value).
• Intrinsic value + Time value + Volatility value = Price of Option
• For example: An investor purchases a three-month Call option at a strike
price of $80 for a volatile security that is trading at $90.
• Intrinsic value = $10 
Time value = since the Call is 90 days out, the premium would add
moderately for time value. 
Volatility value = since the underlying security appears volatile, there would
be value added to the premium for volatility.
 Pricing Options
• Top three influencing factors affecting options prices:
• the underlying equity price in relation to the strike price
(intrinsic value)
• the length of time until the option expires (time value)
• and how much the price fluctuates (volatility value)
• Other factors that influence option prices (premiums) including:
• the quality of the underlying equity
• the dividend rate of the underlying equity
• prevailing market conditions
• supply and demand for options involving the underlying equity
• prevailing interest rates
 Black Scholes option pricing Model,
Index Options
• The Black Scholes Model is one of the most important
concepts in modern financial theory. The Black Scholes
Model is considered the standard model for valuing
options. A model of price variation over time of financial
instruments such as stocks that can, among other things,
be used to determine the price of a European call option.
The model assumes that the price of heavily traded assets
follow a geometric Brownian motion with constant drift
and volatility. When applied to a stock option, the model
incorporates the constant price variation of the stock, the
time value of money, the option’s strike price and the time
to the option’s expiry. Fortunately one does not have to
know calculus to use the Black Scholes model.
 Black Scholes option pricing Model,
Index Options
• Black-Scholes Model Assumptions 
• There are several assumptions underlying the Black-
Scholes model of calculating options pricing..
• The exact 6 assumptions of the Black-Scholes Model are :
• Stock pays no dividends.
• Option can only be exercised upon expiration.
• Market direction cannot be predicted, hence “Random
Walk.”
• No commissions are charged in the transaction.
• Interest rates remain constant.
• Stock returns are normally distributed, thus volatility is
constant over time.
 Black Scholes option pricing Model,
Index Options
• Limitations of the Black Scholes Model
• The Black-Scholes Model assumes that the risk-free rate and the stock’s volatility are
constant.
• The Black-Scholes Model assumes that stock prices are continuous and that large
changes (such as those seen after a merger announcement) don’t occur.
• The Black-Scholes Model assumes a stock pays no dividends until after expiration.
• Analysts can only estimate a stock’s volatility instead of directly observing it, as they
can for the other inputs.
• The Black-Scholes Model tends to overvalue deep out-of-the-money calls and
undervalue deep in-the-money calls.
• The Black-Scholes Model tends to misprice options that involve high-dividend stocks.
• To deal with these limitations, a Black-Scholes variant known as ARCH, Autoregressive
Conditional Heteroskedasticity, was developed. This variant replaces constant
volatility with stochastic (random) volatility. A number of different models have been
developed all incorporating ever more complex models of volatility. However, despite
these known limitations, the classic Black-Scholes model is still the most popular with
options traders today due to its simplicity.
 Black Scholes option pricing Model,
Index Options
• Limitations of the Black Scholes Model
• The Black-Scholes Model assumes that the risk-free rate and the stock’s volatility are
constant.
• The Black-Scholes Model assumes that stock prices are continuous and that large
changes (such as those seen after a merger announcement) don’t occur.
• The Black-Scholes Model assumes a stock pays no dividends until after expiration.
• Analysts can only estimate a stock’s volatility instead of directly observing it, as they
can for the other inputs.
• The Black-Scholes Model tends to overvalue deep out-of-the-money calls and
undervalue deep in-the-money calls.
• The Black-Scholes Model tends to misprice options that involve high-dividend stocks.
• To deal with these limitations, a Black-Scholes variant known as ARCH, Autoregressive
Conditional Heteroskedasticity, was developed. This variant replaces constant
volatility with stochastic (random) volatility. A number of different models have been
developed all incorporating ever more complex models of volatility. However, despite
these known limitations, the classic Black-Scholes model is still the most popular with
options traders today due to its simplicity.
 Black Scholes option pricing Model,
Index Options
• Variants of the Black Scholes Model 
• There are a number of variants of the original Black-Scholes model. As the
Black-Scholes Model does not take into consideration dividend payments
as well as the possibilities of early exercising, it frequently under-values
Amercian style options.
• As the Black-Scholes model was initially invented for the purpose of pricing
European style options a new options pricing model called the Cox-
Rubinstein binomial model is also used. It is commonly known as
the Binomial Option Pricing Model or more simply, the Binomial Model,
which was invented in 1979. This options pricing model was more
appropriate for American Style options as it allows for the possibility of
early exercise.
• The Binomial Option Pricing Model (BOPM), invented by Cox-Rubinstein,
was originally invented as a tool to explain the Black-Scholes Model to
Cox’s students. However, it soon became apparent that the binomial
model is a more accurate pricing model for American Style Options. 
 Black Scholes option pricing Model,
Index Options
• Index Options
• An index option is a financial derivative that gives the holder the right,
but not the obligation, to buy or sell the value of an underlying index,
such as the Standard and Poor’s (S&P) 500, at the stated exercise price
on or before the expiration date of the option. No actual stocks are
bought or sold; index options are always cash-settled, and are typically
European-style options.
• Index call and put options are simple and popular tools used by
investors, traders and speculators to profit on the general direction of an
underlying index while putting very little capital at risk. The profit
potential for long index call options is unlimited, while the risk is limited
to the premium amount paid for the option, regardless of the index
level at expiration. For long index put options, the risk is also limited to
the premium paid, and the potential profit is capped at the index level,
less the premium paid, as the index can never go below zero.
 Hedging with Index Options
• An alternative to selling index futures to hedge a
portfolio is to sell index calls while simultaneously
buying an equal number of index puts. Doing so will lock
in the value of the portfolio to guard against any
adverse market movements. This strategy is also known
as a protective index collar.
• The idea behind the index collar is to finance the
purchase of the protective index puts using the
premium collected from selling the index calls. However,
as a result of selling the index calls, in the event that the
fund manager’s expectation of a falling market is wrong,
his portfolio will not benefit from the rising market.
 Hedging with Index Options
• Implementation
• To hedge a portfolio with index options, we need to first
select an index with a high correlation to the portfolio we
wish to protect. For instance, if the portfolio consist of
mainly technology stocks, the Nasdaq Composite Index
might be a good fit and if the portfolio is made up of mainly
blue chip companies, then the Dow Jones Industrial Index
could be used.
• After determining the index to use, we calculate how many
put and call contracts to buy and sell to fully hedge the
portfolio using the following formula.
• No. Index Options Required = Value of Holding / (Index
Level x Contract Multiplier)
 Hedging with Index Options
• Implementation
• To hedge a portfolio with index options, we need to first
select an index with a high correlation to the portfolio we
wish to protect. For instance, if the portfolio consist of
mainly technology stocks, the Nasdaq Composite Index
might be a good fit and if the portfolio is made up of mainly
blue chip companies, then the Dow Jones Industrial Index
could be used.
• After determining the index to use, we calculate how many
put and call contracts to buy and sell to fully hedge the
portfolio using the following formula.
• No. Index Options Required = Value of Holding / (Index
Level x Contract Multiplier)
 Speculation and Arbitrage in
Currency Futures
• Speculation:
• Future contracts are extremely attractive for
speculators as they provide tremendous
leverage. By paying a small margin amount,
speculators can take higher exposure of the
underlying, thereby increasing their reward
potential as well as the risk. A person who is
bullish on the price of the underlying can BUY a
future contract while a person who is bearish
would SELL the future contract.
 Speculation and Arbitrage in
Currency Futures
• Hedging:
• Hedging is an act of protecting or guarding the investment
against an undesired price movement. Suppose a long term
investor owns a portfolio of stocks worth Rs 10 lacs. Although
he is optimistic about the stocks he has in the portfolio, he is
not very comfortable with the overall movement of the
market. The price movement of a stock is dependent both on
the micro (profitability of the company, its growth potential,
business model, management competency etc) and the macro
factors (GDP growth of the country, interest rates, overall state
of economy etc). Such an investor can hedge his portfolio by
selling Index Futures (like Nifty future) and thereby removing
the risk of macro variables from his portfolio.
 Speculation and Arbitrage in
Currency Futures
• Arbitrage:
• An arbitrageur gains by buying the stock and
going short in its future contract when the price
of the future contract is higher than its
theoretical price. When the price of the future
contract is less than what it should be, the
arbitrageur gains by going long in the future
contract and selling the underlying in cash
market.
Index Options Market in Indian Stock Market

• Futures contract based on an index i.e. the underlying

asset is the index, are known as Index Futures Contracts.
For example, futures contract on NIFTY Index and BSE-
30 Index. These contracts derive their value from the
value of the underlying index.
• Similarly, the options contracts, which are based on
some index, are known as Index options contract.
However, unlike Index Futures, the buyer of Index Option
Contracts has only the right but not the obligation to buy
/ sell the underlying index on expiry. Index Option
Contracts are generally European Style options i.e. they
can be exercised / assigned only on the expiry date.
Use of different option strategies to mitigate
the risk
• Many investors mistakenly believe that options are always riskier
investments than stocks because they may not fully understand the
concept of leverage. However, if used properly, options may carry
less risk than an equivalent stock position. Read on to learn how to
calculate the potential risk of options positions and how the power of
leverage can work in your favor.
• Leverage has two basic definitions applicable to options trading. The
first defines leverage as the use of the same amount of money to
capture a larger position. This is the definition that gets investors into
the most trouble. A dollar invested in a stock and the same dollar
invested in an option do not equate to the same risk.
• The second definition characterizes leverage as maintaining the same
sized position, but spending less money doing so. This is the
definition of leverage that a consistently successful trader or investor
incorporates into his or her frame of reference.
 Use of different option strategies to mitigate
the risk
• Interpreting the Numbers
• Consider the following example. You’re planning to invest $10,000 in a $50 stock
but are tempted to buy $10 options contracts as an alternative. After all,
investing $10,000 in a $10 option allows you to buy 10 contracts (one contract is
worth one hundred shares of stock) and control 1,000 shares. Meanwhile,
$10,000 in a $50 stock will only buy 200 shares.
• In this example, the options trade has more risk than the stock trade. With the
stock trade, your entire investment can be lost but only with an improbable price
movement from $50 to $0. However, you stand to lose your entire investment in
the options trade if the stock simply drops to the strike price. So, if the option
strike price is $40 (an in-the-money option), the stock only needs to drop below
$40 by expiration for the investment to be lost, even though its just a 20%
decline.
• Clearly, there is a huge risk disparity between owning the same dollar amount of
stocks and options. This risk disparity exists because the proper definition of
leverage was applied incorrectly. To correct this misunderstanding, let’s examine
two ways to balance risk disparity while keeping the positions equally profitable.
Use of different option strategies to mitigate
the risk
• Conventional Risk Calculation
• The first method to balance risk disparity is the
standard and most popular way. Let’s go back to our
example to see how this works:
• If you were going to invest $10,000 in a $50 stock, you
would receive 200 shares. Instead of purchasing the
200 shares, you could also buy two call option
contracts. By purchasing the options, you spend less
money but still control the same number of shares. In
other words, the number of options is determined by
the number of shares that could have been bought
with the investment capital.
Use of different option strategies to mitigate
the risk
• Alternative Risk Calculation
• The other alternative for balancing cost and size disparity is
based on risk.
• As we’ve learned, buying $10,000 in stock is not the same
as buying $10,000 in options in terms of overall risk. In fact,
the options exposure carries much greater risk due to
greatly increased potential for loss. In order to level the
playing field, you must have a risk-equivalent options
position in relation to the stock position.
• Let’s start with the stock position: buying 1,000 shares at
$41.75 for a total investment of $41,750. Being a risk-
conscious investor, you also enter a stop-loss order, a
prudent strategy that is advised by market experts.
Use of different option strategies to mitigate
the risk
• You set a stop order at a price that will limit your loss to 20% of the
investment, which calculates to $8,350. Assuming this is the amount you are
willing to lose, it should also be the amount you are willing to spend on an
options position. In other words, you should only spend $8,350 buying
options for risk equivalency. With this strategy, you have the same dollar
amount at risk in the options position as you were willing to lose in the stock
position.
• If you own stock, stop orders will not protect you from gap openings. With an
options position, once the stock opens below the strike price, you have
already lost all that you can lose, which is the total amount of money you
spent purchasing the calls. If you own the stock, you can suffer much greater
loss so the options position becomes less risky than the stock position.
• Say you purchase a biotech stock for $60 and it gaps down at $20 when the
company’s drug kills a test patient. Your stop order will be executed at $20,
locking in a catastrophic $40 loss. Clearly, your stop order didn’t afford much
protection in this case.
Use of different option strategies to mitigate
the risk
• However, say you pass on stock ownership and instead
buy the call options for $11.50. Your risk scenario now
changes dramatically because you are only risking the
amount of money you paid for the option. Therefore, if
the stock opens at $20, your friends who bought the stock
will be out $40, while you will have lost $11.50. Options
become less risky than stocks when used in this manner.
• Determining the appropriate amount of money to invest
in an options position allows the investor to unlock the
power of leverage. The key is maintaining balance in the
total risk is to run a series of “what if” scenarios, using risk
tolerance as your guide.