Futures and Options – The basics.

Option valuation: Upper bounds and lower bounds -Part II

Having learned the upper and lower limits of European calls, next we’ll look at the upper and lower bounds of European put options.

Upper bound of European puts.

Let’s take an example – the stock of HFDC is trading at 800 right now. 1year put options on this stock are available at a strike price of 900. If we calculate the present value of 900 at 8% risk free interest rate, we’ll get 833.50 as the answer.

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Option valuation: Upper bounds and lower bounds – Part 1

What are upper and lower bounds of options?

One important principle while valuing options is that at any time, the value of a call or a put cannot exceed certain limits – on the higher side as well as on the lower side. In option lingo, the maximum limit up to which an option value can go on the higher side is commonly referred to as ‘upper bounds of an option’ and the maximum limit below which an option value cannot fall is called the ‘lower bounds of an option’.

These maximum limits will have to be discussed for European and American options separately. We first take up the upper and lower bounds of European calls.

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Option valuation: Introduction

From this post onwards we will be discussing the various aspects of option pricing. The price of an option at expiry has been already discussed. Now, we need to find out the value of options before expiry- for that,

First, we lay down the factors that affect option price:

  • Strike price – You will have to pay a higher premium, if the strike price of a call is low. For example – if the value of HDFC call with a strike price of 500 is Rs 10, then the value HDFC call with a strike price of 480 would be higher than Rs 10, say 12. Simple logic, since, a lower strike gives the holder the right to buy that share at a lower price. Hence, it’s more valuable and premium will be high.

Puts with higher strike prices will also command higher premium. The reason is that it gives the buyer a right to sell the stock at a higher price.

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Futures vs. options

FUTURES VS OPTIONS

Having explained so far, we are hopeful that you’ll be able to chart out the difference between a futures and options.

Both are traded in stock exchanges and both are derivative instruments. Option and futures are highly standardized and liquidity is always ensured by the exchange that stands as a guarantor of performance. Both instruments are used for protecting asset positions held and also for pure speculation. In India, both futures and options expire on the last Thursday of every month.  That’s the similarity. Now to the differences:

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