Note: The following four pages are a quick reiteration of the subject of index options. For a more detailed explanation, the reader should refer to “Funadamentals of the Stock Market“, where the subject is presented in great detail.
Kinds of stock options
Purchase options – (Call) Give the holder the right to pruchase, at the exercise date of the option, any underlying asset called the base asset at a price which is know and fixed in advance. This known price is reffered to s the strike price.
Sale option – (Put) Give the holder the right to sell, t the exercise date of the option, any asset known as the base asset, at a price which is known and fixed in advance. This known price is the strike price.
Every option is characterized by 4 pieces of data:
The Base asset (gold, iron or any other asset).
Option type: Call or Put.
Expiry date which is also the exercise date.
DJ Index options
The 4 pieces of data for the DJ index options are:
Base asset – the DJ Index.
Option type – Call or Put.
Exercise index – for each option, a DJ index number is recorded from which the strike price is derived.
Expiry date which is also the exercise date – the 3rd Friday of the month.
The option name contains all the data relating to it.For example, an option named C340 May, includes the following data:
The base asset of all DJ Index option is the DJ Index, and thus stating its name is redundant.
2 Option Type
3 Exercise Index
4 Expiry Date
The base asset price
Each index has its own underlying asset. The underlying sset for the DJIA is the DJX, calculated by dividing the DJIA by 100.
The price of the base asset at any particular date is found by multiplying the DJ Index at that date by $100. In fact, each DJ index point s equal to $100.
For exmple: If the DJ Index stands at 350 poinyts, the base asset is $35, 000.
The Exercise price
The Exercise price is found by multiplying the preset DJ Index of the option by $100. For example, if the present DJ Index of the option is 340 points, the exercise price would be $34,000.
Another way is to view each option as rpresenting right to buy or sell 100 DJ Index units at price equal to the Exercise price.
For example: The option Call340 May represents a right to buy 100 DJ Index units at a price of $340.
Profitability of Exercising Options and Calculation of profit
Every option enables us to carry out a transaction at the expiry dte of the option. In the case of Call options, the transaction is to buy the DJ Index at the strike price (which is set in advance) and to sell it at the market price, which is the price of the base asset (see examples in the next slide).
In the case of Put options the transaction is to buy the DJ Index at the market price and to sell it (at the expiry date of the option) at the strike price. We carry out these transctions only if we can buy cheap and sell expensive.
The profitablility of exercising the transacstion is affected by only two pieces of data:
The price of the base asset.
The strike price.
Examples: In calculating the profit in the following examples, we have ignored the purchase price of the option. In order to obtain the net profit we need to deduct from the profit, which is calculated below, the price we paid in order to purchase the option
1. Call option:
We are holding a C360My option, and the index at the end of May is 380 points. In this situation it is worth our while to exercise the option. Our profit will be $2,000, obtaiined from the following calculation:
Base asset price (sale price) (DJ Index X$100) $38, 000
Strike price (purchase price) (DJ Index X $100) $36, 000
Profit $2, 000
2. Put option:
We are holding a P370May option, and the index at the end of May is 360 points. In this situation it is worth our while to exercise the option. Our profit will be $1,000, obtained from the following calcultion:
Strike price (sale price) (DJ index X$100) $37, 000
Base asset price (purchase price) (DJ Index X $100) $36, 000
Profit $1, 000