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4. LITERATURE REVIEW
The authors Black, Fisher, and Scholes ,Myron, themselves admitted some biases of the
model in their research paper, The Valuation of Option Contracts and a Test of Market
Efficiency, expressed as Using the past data to estimate the variance caused the model to
overprice options on high variance stocks and under price options on low variance stocks. While
the model tends to overestimate the value of an option on a high variance security, market tends
to underestimate the value, and similarly while the model tends to underestimate the value of an
option on a low variance security, market tends to overestimate the value.
During 1979, Macbeth, James D., and Merville, Larry J. in their research paper, An
Empirical Examination of the Black - Scholes Call Option pricing Model revealed that B-S
model predicted prices are on average less (greater) than market prices for in the money options
(out of the Money) and also had biases over the life of the options also.
Investors are given the choice to buy or sell the security at a specific price by a specific
time, but they are not required to do so.
(Essential Concepts, Third Edition by the Options Institute).
Options trading has the reputation of being a speculative and very risky form of
securities trading.
(Options for the Stock Investor, by James Bittman)
Option trading is a risky but often very profitable business. Option Trading is simply the
trade in option contracts over an exchange.
(Options as a Strategic Investment, by Lawrence McMillan)

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DERIVATIVES
Derivative is a product whose value is derived from the value of one or more basic
variables, called bases (underlying asset, index, or reference rate), in a contractual manner.
The underlying asset can be equity, forex, commodity or any other asset.

DERIVATIVE PRODUCTS
Derivative contracts have several variants. The most common variants are forwards,
futures, options and swaps. Here is a brief look at various derivatives contracts that have come
to be used.

FORWARDS: A forward contract is a customized contract between two entities, where

settlement takes place on a specific date in the future at today's pre-agreed price.

FUTURES: A futures contract is an agreement between two parties to buy or sell an asset
at a certain time in the future at a certain price. Futures contracts are special types of forward
contracts in the sense that the former are standardized exchange-traded contracts.

OPTIONS: Options are of two types - calls and puts. Calls give the buyer the right but not
the obligation to buy a given quantity of the underlying asset, at a given price on or before a
given future date. Puts give the buyer the right, but not the obligation to sell a given quantity
of the underlying asset at a given price on or before a given date.

WARRANTS: Options generally have lives of up to one year, the majority of options
traded on options exchanges having a maximum maturity of nine months. Longer-dated
options are called warrants and are generally traded over-the-counter.

LEAPS: The acronym LEAPS means Long-Term Equity Anticipation Securities. These are
options having a maturity of up to three years.

BASKETS: Basket options are options on portfolios of underlying assets. The underlying
asset is usually a moving average of a basket of assets. Equity index options are a form of
basket options.
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SWAPS: Swaps are private agreements between two parties to exchange cash flows in the
future according to a prearranged formula. They can be regarded as portfolios of forward
contracts. The two commonly used swaps are.
INTEREST RATE SWAPS: These entail swapping only the interest related cash flows
between the parties in the same currency.
CURRENCY SWAPS: These entail swapping both principal and interest between the parties,
with the cash flows in one direction being in a different currency than those in the opposite
direction.

SWAP OPTIONS: Swap options are options to buy or sell a swap that will become
operative at the expiry of the options. Thus, a swap option is an option on a forward swap.
Rather than have calls and puts, the swap options market has receiver swap options and payer
swap options. A receiver swap option is an option to receive fixed and pay floating. A payer
swap option is an option to pay fixed and receive floating.

OPTIONS:
An option is a contract that gives the buyer or seller the right, but not the obligation,
to buy or sell an underlying asset at a specific price on or before a certain date. An option, just
like a stock or bond, is a security. It is also a binding contract with strictly defined terms and
properties.
The two types of options:
A call gives the holder the right to buy an asset at a certain price within a specific
period of time. Calls are similar to having a long position on a stock. Buyers of calls hope that
the stock will increase substantially before the option expires.
A put gives the holder the right to sell an asset at a certain price within a specific
period of time. Puts are very similar to having a short position on a stock. Buyers of puts hope
that the price of the stock will fall before the option expires.

OPTION TERMINOLOGY
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Index options: These options have the index as the underlying. Some options are
European while others are American. Like index futures contracts, index options contracts
are also cash settled.
Stock options: Stock options are options on individual stocks. Options currently trade on
over 500 stocks in the United States. A contract gives the holder the right to buy or sell
shares at the specified price.
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 of an option: The writer 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.
There are two basic types of options, call options and put options.
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 up to
the expiration date. Most exchange-traded options are American.
European options: European options are options that can be exercised only on the
expiration date itself. European options are easier to analyze than American options, and
properties of an American option are frequently deduced from those of its European
counterpart.
In-the-money option: An in-the-money (ITM) option is an option that would lead to a
positive cash flow to the holder if it were exercised immediately. A call option on the index
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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 cash flow 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 cash flow 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.
THE RELATIONSHIP BETWEEN THE OPTIONS STRIKE PRICE AND MARKET
PRICE:
MARKET SCENARIO

CALL OPTION

PUT OPTION

Market price>strike price

In-the-money

Out-of-the-money

Market price<strike price

Outof-the-money

In-the-money

Market price=strike price

At-the-money

At-the-money

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.

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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.

HOW THE OPTIONS MARKET WORK

Options are contracts on some underlying trading instrument - shares of stock, bonds,
a commodity, a mortgage loan, etc. But regardless of what the option is on, there are common
features. One of the most basic is the contract feature specifying what the option owner has
actually contracted for.

CALL:
A 'call' confers on the (option) contract holder the right to buy an asset at a stated
price on or before a specified expiration date. A right to buy not an obligation. The call owner
always has the option to let his option expire. (Of course, he then loses the initial money
invested in buying the contract.)
Call buyers are betting the underlying asset - the stock, bond, commodity, etc - will
increase in price before the expiration date. And, not only rise, but rise enough to make a
profit.

PUT:
A 'put', by contrast, gives the option buyer the right to sell an asset at a certain price by
a stated date. The right, not the obligation,
Puts are similar to 'shorting stock', in this sense. Put buyers are betting the stock price
will fall before the option expires.

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In this case the market price must fall below the strike price in order to garner a profit
from exercising the option. (Ignoring the cost of the put, for simplicity.) Under those
circumstances, the option holder is 'in the money'.

ECONOMIC IMPORTANCE OF THE OPTIONS MARKET

There are two main reasons why an investor would use options: to speculate and to hedge.

SPECULATION

HEDGING

SPECULATION:
You can think of speculation as betting on the movement of a security. The advantage
of options is that you aren't limited to making a profit only when the market goes up. Because
of the versatility of options, you can also make money when the market goes down or even
sideways
Speculation is the territory in which the big money is made - and lost. The use of
options in this manner is the reason options have the reputation of being risky. This is because
when you buy an option; you have to be correct in determining not only the direction of the
stock's movement, but also the magnitude and the timing of this movement.

To succeed, you must correctly predict whether a stock will go up or down, and you
have to be right about how much the price will change as well as the time frame it will take
for all this to happen. And don't forget commissions the combinations of these factors means
the odds are stacked against you.

HEDGING:
The other function of options is hedging. Think of this as an insurance policy. Just
as you insure your house or car, options can be used to insure your investments against a
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downturn. Critics of options say that if you are so unsure of your stock pick that you need a
hedge, you shouldn't make the investment.
On the other hand, there is no doubt that hedging strategies can be useful, especially
for large institutions. Even the individual investor can benefit. Imagine that you wanted to
take advantage of technology stocks and their upside, but say you also wanted to limit any
losses. By using options, you would be able to restrict your downside while enjoying the full
upside in a cost-effective way.

SETTLEMENT OF OPTIONS CONTRACTS:

Options contracts have three types of settlements they are:
Daily premium settlement.
Exercise settlement.
Interim exercise settlement. In case of option contracts on securities and final
settlement.

DAILY PREMIUM SETTLEMENT:

Buyer of an option is obligated to pay the premium towards the options purchased by
him. Similarly, the seller of an option is entitled to receive the premium for the option sold by
him. The premium payable amount and the premium receivable amount are netted to compute
the net premium payable or receivable amount for each client for each option contract.

EXERCISE SETTLEMENT:
Although most option buyers and sellers close out their options positions by an
offsetting closing transaction, an understanding of exercise can help an option buyer
determine whether exercise might be more advantageous than an offsetting sale of the option.
There is always a possibility of the option seller being assigned an exercise. Once an exercise
of an option has been assigned to an option seller, the option seller is bound to fulfill his
obligation (meaning, pay the cash settlement amount in the case of a cash-settled option) even
though he may not yet have been notified of the assignment.
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INTERIM EXERCISE SETTLEMENT:

Interim exercise settlement takes place only for option contracts on securities. An
investor can exercise his in-the-money options at any time during trading hours.
Through his trading member. Interim exercise settlement is effected for such options at
the close of the trading hours, on the day of exercise. Valid exercised option contracts are
assigned to short positions in the option contract with the same series (i.e. having the same
underlying, same expiry date and same strike price), on a random basis, at the client level. The
CM who has exercised the option receives the exercise settlement value per unit of the option
from the CM who has been assigned the option contract.

FINAL EXERCISE SETTLEMENT:

Final exercise settlement is effected for all open long in-the-money strike price options
existing at the close of trading hours, on the expiration day of an option contract. All such
long positions are exercised and automatically assigned to short positions in option contracts
with the same series, on a random basis. The investor who has long in-the-money options on
the expiry date will receive the exercise settlement value per unit of the option from the
investor who has been assigned the option contract.

EXERCISE PROCESS:
The period during which an option is exercisable depends on the styl of the option. On
NSE, index options are European style, i.e. options are only subject to automatic exercise on
the expiration day, if they are in-the-money. As compared to this, options on securities are
American style. In such cases, the exercise is automatic on the expiration day, and voluntary
prior to the expiration day of the option contract, provided they are in-the-money.

PARTICIPANTS IN THE OPTIONS MARKET

There are four types of participants in the options markets depending on the position they take:
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1.
2.
3.
4.

LITERATURE REVIEW

Buyers of calls
Sellers of calls
Buyers of puts
Sellers of puts
People who buy options are called holders and those who sell options are called
writers; furthermore, buyers are said to have long positions, and sellers are said to have
short positions.

BUYER OF CALL OPTION:

The buyer of an equity call options has purchased the right, but not the obligation, to buy
100 shares of the underlying stock at the stated exercise price at any time before the option
expires. Once the option is purchased, the buyer is then long the call contract, and to purchase
100 underlying shares he notifies his brokerage firm of his intent to exercise the call contract.
Profit +

profit unlimited

Increasing Underlying Stock Price

Loss=
Limited
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Long call
Pay-off profile of buyer of call option

Potential profit: Unlimited as the underlying stock price increases.

Potential loss : Limited to premium paid for call option.

WRITER (SELLER) OF CALL OPTION:

An investor who sells an option contract that he does not already own is known as the
option writer, and is then short the contract. The writer of an equity call option, commonly
referred to as the seller has the obligation to sell 100 shares of the underlying stock at the
stated exercise price if assigned an exercise notice at any time before the option expires.

Profit +
Profit =
Limited 0

Loss -

increasing underlying stock price

Loss=

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Unlimited
Shot call
Pay-off profile of seller of call option

Potential profit: limited to premium received form calls initial sale.

Potential Loss: Unlimited as the underlying stock price increases.

BUYER OF PUT OPTION:

A put option gives the holder the right to sell an asset at a certain price within a specific
period of time. Puts are very similar to having a short position on stock. Buyers of puts hope that
the price of the stock will fall before the option expires.
The buyer of an equity put option has purchased the right, but not the obligation, to sell
100 shares of the underlying stock at the stated exercise price at any time before the option
expires. Once the option is purchased the buyer is then long the put contract, and to sell 100
underlying shares he notifies his brokerage firms of his intent to exercise the put contract

Profit= substantial
Profit +

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increasing underling stock price

Loss = limited
Loss Long put
Pay off profile of buyer of put option
Potential profit: Substantial and increases as the underlying stock price decreases to zero.
Potential loss: Limited to premium paid for put.

WRITER (SELLER) OF PUT OPTION:

An investor who sells an option contract that he does not already own is known as the
option writer and is then short the contract. The writer of an equity put option , commonly
referred to as the seller has the obligation to purchase 100 shares of the underlying stock at the
stated exercise price if assigned an exercise notice at any time before the option expires
Profit= limited
Profit+

Increasing underlying stock price

Loss=
Substantial

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LossShort put
Pay-off profile of seller of put option
Potential profit: limited to premium received form puts initial sale.
Potential loss: Substantial and increases as the underlying stock price decreases to zero.

HERE IS THE IMPORTANT DISTINCTION BETWEEN BUYERS AND SELLERS

Call holders and put holders (buyers) are not obligated to buy are sell; they have the

choice to exercise their rights if they choose.

Call writers and put writers (sellers) however are obligated to buy or sell. This means that
a seller may be required to make good on their Promise to buy or sell.

FOUR ENTITIES IN THE TRADING SYSTEM

1. TRADING MEMBERS:
Trading members are members of NSE. They can trade

either on their own account

or on behalf of their clients including participants. The exchange assigns a trading member ID to
each trading member. Each trading member can have more than one user. The number of users
allowed for each trading member is notified by the exchange from time to time. Each user of a
trading member must be registered with the exchange and is assigned a unique user ID. The
unique trading member ID functions as reference for all orders /trades of different users. This ID
is common for all users of a particular trading member. It is the responsibility of the trading
member to maintain adequate control over persons having access to the firms user IDs.

2. CLEARING MEMBERS:
Clearing members are members of NSCCL they carryout risk management activities and
conformation/enquiry of trades through the trading system.

3. PROFESSIONAL CLEARING MEMBERS:

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A professional clearing member is a clearing member who is not a trading member.

Typically, banks and custodians become professional clearing members and clear and settle for
their trading members.

4. PARTICIPANTS:
A participant is a client of trading members like financial

institutions. These clients

may trade through multiple trading members but settle through a single clearing member.

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