Stock Options

Stock Options Definition

Stock Options are derivative instruments that provide the holder either the right to buy or sell any stock based on the predetermined stock prices regardless of the prevailing market prices.

Generally, the following are its components –

Stock-Options

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Source: Stock Options (wallstreetmojo.com)

Types of Stock Options

The following are the two types –

  • 1 – American Style American option that can be exercised at any time, even before the expiry
  • 2 – European Style European option that can be exercised only at the time of expiry

Calculation and Example

Pay off in options will always be considered at maturity. Initially, while writing or buying options, either premium inflow or outflow will take place. On maturity, Cash inflow (in case of profit) or cash outflow (in case of loss) net off premium will take place.

Hence, the following is the formula of Payoffs:

Payoffs Formula = (Maturity Price – Strike price) * Lot Size – Premium paid on the inception.

Example #1

Call option of Amazon.com :

  • Current market price – $ 30
  • The strike price of the option – $ 40
  • Premium – $ 5
  • The market price on expiry- 1. $ 20,   $ 60
  • Lot size – 100 shares

Solution

If the Market price is $ 20, then it is below the strike price. Hence, the option will lapse.

Hence total loss = $ 5

If the Market price is $ 60, then it is above the strike price. Hence, the option will be exercised.

Calculation of Payoff Maturity 

stock options example 1

Pay off on maturity = ($ 60 – $ 40) * 100 – $ 5

= ($ 20) * 100 – $ 5 = = $ 2000 – $ 5 = $ 1995

Example #2

Mr. A bought the put optionPut OptionPut Option is a financial instrument that gives the buyer the right to sell the option anytime before the date of contract expiration at a pre-specified price called strike price. It protects the underlying asset from any downfall of the underlying asset anticipated.read more of Facebook, Inc. with the expiry of 30th April, on 1st April. On 1st April, the Market price of Facebook, Inc is $ 136. The premium of the Put option for a strike price of $ 150, with the expiry of 30th April, is $ 1000. The lot size is 1000 shares. Calculate the payoff for the option if the market price on 30th April is

  • $ 110 $ 180

Solution

Here Mr. A is the buyer of the Put option. Hence he has the right to buy the share if the price goes below the strike price. On 30th April, if the Market price is $ 110, then it is below the strike price of $ 150.Hence, put is in the money, and options will be exercised.

On 30th April, if the market price is $ 180, then it is above the strike price, and hence calls will lapse.

Therefore, total loss = $ 1000

Calculation of Payoff 

stock options example 2

Therefore, payoff = ($ 150 – $ 110) * 1000 – $ 1000

= $ 40,000 – $ 1000

= $ 39,000

Benefits of Stock Options

Disadvantages of Stock Options

Indicators of the Stock Options

The following are the indicators of Stock option performance:

  • Delta: Degree at which option price will change with respect to change in the market price.
  • Gamma: Degree at which delta( as discussed in 1) of the option is getting the change with respect to change in market price. In simple terms, it is termed as the delta of the delta.
  • Theta: Degree of change in option price with respect to a change in the expiry of option instrument
  • Rho: Degree of change in option price with respect to a change in risk-free interest rate.
  • Vega: Degree of change in option price with respect to the change in volatility.

Conclusion

Stock options are a preferred financial instrument by the asset management companiesAsset Management CompaniesAsset Management Company is a company that takes the financial assets of a person, company or another asset management company (generally this will be high net worth individuals) and use the assets to invest in companies that use those as a operational investment, financial investment or any other investment in order to grow the investment.read more, portfolio managers, foreign institutional investors, etc. It gives the benefit of betting with huge exposure just based on the specific insight of the movement of the stock price in a particular direction.

This has been a guide to Stock Options and its definition. Here we discuss the components, types of stock options along with examples and explanations, benefits, and disadvantages. You can learn more about accounting from the following articles –

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