A Note On Investment Strategies Involving Options

INVESTMENT STRATEGIES INVOLVING OPTIONS

Let us consider a typical option transaction. On April 1, 2002, a person A sells a three-month Rs. 500 European call option on shares of Britannia, which is currently trading at Rs. 470 to B for a price of Rs.3.25. Now B has the right to approach A on July 01, 2002 and buy one share of Britannia at Rs.500. In the transaction, Rs 3.25 is the ‘option premium,'Rs.500 is the ‘exercise price'and July 01, 2002 is the ‘expiration date.'

It is not necessary for B to buy the share on July 01, 2002 at Rs.500 from A (unlike a forward/futures contract, which is binding on both sides). It is only if Britannia's share price is more than Rs.500, on July 01, 2002, that B will find it useful to exercise his right to buy. If B chooses to exercise the option, A is obliged to honor the deal.

In that case, A will have to sell a share of Britannia to B at Rs. 500 on the same day.

Hence, at option expiration, there can be two possible outcomes – an option could be profitably exercised, or it could be allowed to expire being unused. If the option lapses unused, then B has lost the option premium of Rs.3.25 to A. An option can be referred to as in the money, at the money, or out of the money. An ‘in the money'option is one which yields a positive cash flow to the option holder when exercised. An ‘at the money'option would lead to a zero cash flow when exercised while ‘out of the money'option would lead to a negative cash flow if it is exercised immediately. If X is the stock price and Yt is the strike price, a put option is in the money when X < Yt, at the money when X = Yt and out of the money when X > Yt (Refer Table 1).

TABLE 1

IN, AT AND OUT OF THE MONEY OPTIONS

	Put Option	Call Option
In the Money	Strike price (Yt) is greater than the spot price of the underlying asset (X)	Strike price (Yt) is less than the spot price (X).
At the Money	Strike price (Yt) is equal to the spot price of the underlying asset (X)	Strike price (Yt) is equal to the spot price (X).
Out of the Money	Strike price (Yt) is less than the spot price of the underlying asset (X)	Strike price (Yt) is greater than the spot price (X).

Source: Compiled from rediff.com/money/option.htm

For example, a put option on stock A at an exercise price of Rs. 500 is ‘in the money'when the stock at the expiration date is trading below Rs. 500 because the put holder can exercise the option and realize an amount which is greater than the current spot price.