Compliance of Option Contracts

Definitions:
Option:
An option is a derivative financial instrument that establishes a contract between two
parties concerning the buying or selling of an asset at a reference price. The buyer of the
option gains the right, but not the obligation, to engage in some specific transaction on
the asset, while the seller incurs the obligation to fulfill the transaction if so requested by
the buyer. The price of an option derives from the difference between the reference price
and the value of the underlying asset (commonly a stock, a bond, a currency or a futures
contract) plus a premium based on the time remaining until the expiration of the option.

An option on a futures contract is the right, but not the obligation, to buy or sell a
particular futures contract at a specific price on or before a certain expiration date. There
are two types of options: call options and put options. Each offers an opportunity to take
advantage of futures price moves without actually having a futures position. When a call
option is exercised, the holder acquires from the writer a long position in the underlying
futures contract plus a cash amount equal to the excess of the futures price over the strike
price. When a put option is exercised, the holder acquires a short position in the
underlying futures contract plus a cash amount equal to the excess of the strike price over
the futures price

Put option:
The buyer of the call option has the right, but not the obligation to buy an agreed quantity
of a particular commodity or financial instrument (the underlying) from the seller of the
option at a certain time (the expiration date) for a certain price (the strike price). The
seller (or, writer) is obligated to sell the commodity or financial instrument, if the buyer
decided to executed the option contract. The buyer pays a fee (called a premium) for this
right.

Call option:
The buyer acquires a short position by purchasing the right to sell the underlying
instrument to the seller of the option for a specified price (the strike price) during a
specified period of time. If the option buyer exercises his right, the seller is obligated to
buy the underlying instrument from him at the agreed-upon strike price, regardless of the
current market price. In exchange for having this option, the buyer pays the seller or
option writer a fee (the option premium).

Strike Price:
Also known as the exercise price, the strike price is the price at which the option buyer
may buy or sell the underlying futures contracts. Exercising the option, results in a
futures position at the designated strike price. Strike prices are set by the Exchange and
have different intervals depending on the underlying contract. Strike prices are set above
and below the existing futures price and additional strikes are added if the futures move
significantly up or down.
Calculation of Strike Price:
When a new expiration date is introduced, the two or three strike prices closest to the
current market price are usually selected by the exchange. If the stock price moves
outside the range defined by the highest and lowest strike price, trading usually
introduced in an option with a new strike price. To illustrate these rules, suppose that the
securities price is Rs 84 when trading begins in the October options. Call and put options
would probably first be offered with strike prices of Rs 80, Rs 85 ad Rs 90. If the
securities price rose above Rs 90, it is likely that a strike price of Rs 95 would be offered;
if it fell below Rs 80, it is likely that a strike price of Rs 75 would be offered and so on.

Margin:
Margin for the buyer:
Premium+ Rs 5,000

Margin for the seller:

As per the futures contract

Margin call:
There will be no margin call for the option buyer. Where as option seller have to maintain
margin as per the futures contract.

Premium:
The premium is the price that the buyer of an option pays and the seller of an option
receives for the rights conveyed by an option. Thus, ultimately the cost of an option is
determined by supply and demand. Various factors affect options premiums, including
strike price level in relation to the futures price level; time remaining to expiration; and
market volatility—all of which will be discussed further. There are two components to
the options premium and they are intrinsic value and time value.

Intrinsic Value:
The intrinsic value of a call is the amount the option is ITM (In the Money), if it is
ITM. If the call is OTM (Out of the Money), its intrinsic value is zero. Putting it
another way, the intrinsic value of a call is Max [0, (S T – 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. greater of 0 or (K – ST). K is the strike price and ST
is the spot price.

Time Value:
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 and ATM has
only time value. Usually, the maximum time value exits 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.
Profit/Loss:
1) Buyer of call option:

Figure: Profit loss buying a European call option

It is often to characterize European option position is terms of the terminal value

of payoff to the investor at maturity. The initial cost of the option is then not
included in the calculation. If K is the strike price and ST is the final price of the
underlying asset, the payoff for buyer in a European call option is
Max [(ST – K), 0]

2) Seller of call option:

Figure: Profit loss selling a European call option

This reflects the fact that the option will be exercised if ST > K and will not be
exercised if ST ≤ K. The payoff for seller in the European call option is
Min [(K – ST), 0]

1) Buyer of put option:

Figure: Profit loss buying a European put option

Payoff for to the buyer of a European put option is
Max [(K – ST), 0]
 4) Seller of put option:

Figure: Profit loss selling a European put option

And payoff for short position in a European put option is

Min [(ST – K), 0]

Transaction cost (Commission):

Before you decide to buy and/or write (sell) options, you should understand the other
costs involved in the transaction—commissions and fees. Commission is the amount of
money, per option purchased or written, that is paid to the brokerage firm for its services,
including the execution of the order on the trading floor of the exchange. The
commission charge increases the cost of purchasing an option and reduces the sum of
money received from writing an option. In both cases, the premium and the commission
should be stated separately.
The commission for the transaction of option contract will be as per futures contract.

Tax:
The tax rate will be as per the government polices.

Calculation: As per σ (Sigma) and with parity/disparity

Settlement: Strictly on the expiry of futures price (European Option)