An Option is a contract that trades in stock exchanges that gives the right, but not an obligation, to buy or sell the underlying assets on or before a specified date and at a specified price. While the buyer of the option pays the premium and buys the right, the writer/seller of the option takes the premium with an obligation to sell/ buy the underlying asset if the buyer exercises his right. For equity options, the underlying assets are a stock, exchange-traded fund (ETF), or similar product.
The option buyer has the right but no obligation with concerns to buying or selling the underlying asset, while the option seller has the obligation in the contract. Therefore, the option buyer will exercise his option only when the position is beneficial to him, but, when he decides to exercise, the option seller would be legally bound to honour the contract.
The contract itself is exact. It establishes a specific price, called the strike price, at which the contract may be exercised. And it has an expiration date. When an option expires, it no longer has value and no longer exists.
Options come in two types, Calls Options and Puts Options, and you can buy or sell either type. You make those choices—whether to buy or sell and whether to choose a call or a put—depending on what you want to achieve as an options trader. Option, which gives the buyer a right to buy the underlying asset, is called the Call option and the option which gives the buyer a right to sell the underlying asset, is called the Put option.
You guys understood what an option is. If not let’s break it down with an example. Assume there is an insurance company XYZ for the stock market and there is a company MNO trading at Rs.100. You are holding 50 shares MNO company and you think that the share price of this company might fall. So, you don’t want to take risk of price falling and you also don’t want to miss out on the opportunity if the company share price increase. So, you go to XYZ company and say I want to insure my share at Rs.90. Then the company might quote you Rs. 2 per share as a premium. So, your total cost will be Rs. 2*50 shares=Rs.100.
Now imagine that the price of the stock goes down to Rs. 80 per share, you can use your insurance and the company is obliged to buys the share at Rs. 90 per share even though the share is trading at Rs. 80. And if the price moves up or stays the same the company will keep the premium of Rs. 2 per share. This is the function of the put option. Company XYZ is selling a put option and you are buying a put option.
Buying and Selling
If you buy a call, you have the right to buy the underlying assets at the strike price on or before the expiration date. If you buy a put, you have the right to sell the underlying assets on or before the expiration date. In either case, as the option holder, you also have the right to sell the option to another buyer during its term or to let it expire worthless.
The situation is different if you write, or sell, an option since selling obligates you to fulfill your side of the contract if the holder wishes to exercise. If you sell a call, you’re obligated to sell the underlying interest at the strike price, if you’re assigned. If you sell a put, you’re obligated to buy the underlying interest, if assigned. As an option seller, you have no control over whether or not a contract is exercised, and you need to recognize that exercise is always possible at any time until the expiration date. But just as the buyer can sell an option back into the market rather than exercising it, as a seller you can purchase an offsetting contract and end your obligation to meet the terms of the contract.
Premium
When you buy an option, the purchase price is called the premium. If you sell, the premium is the amount you receive. The premium isn’t fixed and changes constantly—so the premium you pay today is likely to be higher or lower than the premium yesterday or tomorrow. What those changing prices reflect is the give and take between what buyers are willing to pay and what sellers are willing to accept for the option. The point at which there’s agreement becomes the price for that transaction, and then the process begins again. If you buy options, you start out with what’s known as a net debit. That means you’ve spent money you might never recover if you don’t sell your option at a profit or exercise it. And if you do make money on a transaction, you must subtract the cost of the premium from any income you realize to find your net profit. As a seller, on the other hand, you begin with a net credit because you collected the premium. If the option is never exercised, you keep the money. If the option is exercised, you still get to keep the premium but are obligated to buy or sell the underlying stock if you’re assigned.
The value of options
What a particular options contract is worth to a buyer or seller is measured by how likely it is to meet their expectations. In the language of options, that’s determined by whether or not the option is, or is likely to be, in-the-money or out-of-the-money at expiration. A call option is in-the-money if the current market value of the underlying stock is above the exercise price of the option, and out-of-the-money if the stock is below the exercise price. A put option is in-the-money if the current market value of the underlying stock is below the exercise price and out-of-the-money if it
is above it. If an option is not in-the-money at expiration, the option is assumed to be worthless. An option’s premium has two parts: an intrinsic value and a time value. Intrinsic value is the amount by which the option is in-the-money. Time value is the difference between whatever the intrinsic value is and what the premium is. The longer the amount of time for market conditions to work to your benefit, the greater the time value.
Options prices
Several factors, including supply and demand in the market where the option is traded, affect the price of an option, as is the case with an individual stock. What’s happening in the overall investment markets and the economy at large are two of the broad influences. The identity of the underlying assets, how it traditionally behaves, and what it is doing at the moment are more specific ones. Its volatility is also an important factor, as investors attempt to gauge how likely it is that an option will move in-the-money.
Opening or closing, Buying or purchasing, writing or selling.
When you buy or sell a new contract, you’re establishing an open position. That means that you’ve created one side of a contract and will be matched anonymously with a buyer or seller on the other side of the transaction. If you already hold an option or have written one, but want to get out of the contract, you can close your position, which means either selling the same option you bought or buying the same option contract you sold.
There are some other options terms to know:
• An options buyer purchases a contract to open or close a position.
• An options holder buys a contract to open a long position.
• An options seller sells a contract to open or to close a position.
• An options writer sells a contract to open a short position.
All options transactions, whether opening or closing, must go through a brokerage firm, so you’ll incur transaction fees and commissions. It’s important to account for the impact of these charges when calculating the potential profit` or loss of an options strategy.
STANDARDIZED TERMS
Index option: These options have an index as the underlying asset. For example, options on Nifty, Sensex, etc.
Stock option: These options have individual stocks as the underlying asset. For example, options on ONGC, NTPC, etc.
Contract size/Lot Size: Lot size is the number of units of the underlying asset in a contract. The lot size of Nifty option contracts is 50. Accordingly, if the price of the call option is Rs 71.70 and the price of the put option is 174.8, the total premium for the call option would be Rs. 71.70 x50 = 3585 and the total premium for put option contract would be Rs. 174.80 x 50 = 8740.
Expiration Day: The day on which a derivative contract ceases to exist. It is the last trading date/day of the contract. In our example, the expiration day of contracts is the last Thursday of September month i.e. 24 September 2015.
Spot price (S): It is the price at which the underlying asset trades in the spot market. In our examples, it is the value of underlying viz. 7,899.15.
Strike price or Exercise price (X): Strike price is the price per share for which the underlying security may be purchased or sold by the option holder. In our examples, the strike price for both call and put options is 8000.
Buyer of an option: The buyer of an option has a right but not the obligation in the contract. For owning this right, he pays a price to the seller of this right called ‘option premium’ to the option seller.
Writer of an option: The writer of an option receives the option premium and is thereby obliged to sell/buy the asset if the buyer of the option exercises his right.
In the money (ITM) option: This option would give the holder a positive cash flow if it were exercised immediately. A call option is said to be ITM when the spot price is higher than the strike price. And a put option is said to be ITM when the spot price is lower than the strike price. Say, for example
, NIFTY is trading at 17300. If you have a call option that has a strike price of Rs.17200, then it is said to be Rs.100 ITM.
At the money (ATM) option: Both call and put ATM options, the strike price is equal to the spot price.
Out of the money (OTM) option: A call option is said to be OTM when the spot price is lower than the strike price. And a put option is said to be OTM when the spot price is higher than the strike price. Say, for example, NIFTY is trading at 17300. If you have a put option that has a strike price of Rs.17100, then it is said to be Rs.100 OTM.
Exercise price: This is the price per share at which 100 shares of the underlying security can be bought or sold at the time of exercise.
Exercise of Options: In the case of the American option, buyers can exercise their option any time before the maturity of the contract. All these options are exercised with respect to the settlement value/ closing price of the stock on the day of exercise of the option.
Assignment of Options: Assignment of options means the allocation of exercised options to one or more option sellers. The issue of assignment of options arises only in the case of American options because a buyer can exercise his options at any point in time.
Type of delivery: Most equity options are physical delivery contracts, which means that shares of stock must change hands at the time of exercise. Most index options are cash-settled, which means the in-the-money holder receives a certain amount of cash upon exercise.
Important Note:
In India, if you are trading in stock options and if the price goes in-the-money, the physical settlement takes place at the time of expiration. So, make sure that stock options traders are ready to take or give delivery according to the option position that they hold. Or square of your position before expiry so that settlement takes place in cash.
Option price/Premium: It is the price that the option buyer pays to the option seller. For example, if the option price for the NIFTY call option of strike price 17300 is Rs. 71.70 the buyer of the option has to pay a total of Rs. 71.70 x 50 = Rs. 3585 per lot (50 being the lot size) to the seller of the option to buy that option.
Style: Options that can be exercised at any point before expiration are American style. Options that can be exercised only on the day of expiration are European style.
Intrinsic value: Option premium, defined above, consists of two components – intrinsic value and time value.
For an option, intrinsic value refers to the amount by which option is in the money i.e. the amount an option buyer will realize, before adjusting for the premium paid, if he exercises the option instantly. Therefore, only in-the-money options have intrinsic value whereas at-the-money and out-of-the-money options have zero intrinsic value. The intrinsic value of an option can never be negative.
Thus, for the call option which is in-the-money, intrinsic value is the excess of spot price (S) over the exercise price (X). Thus, the intrinsic value of the call option can be calculated as S-X, with the minimum value possible as zero because no one would like to exercise his right under no advantage condition.
Similarly, for the put option which is in-the-money, intrinsic value is the excess of the exercise price (X) over the spot price (S). Thus, the intrinsic value of the put option can be calculated as X-S, with the minimum value possible as zero.
Time value: It is the difference between the premium and intrinsic value, if any, of an option. ATM and OTM options will have only a time value because the intrinsic value of such options is zero.
Open Interest: As discussed in the futures section, open interest is the total number of option contracts outstanding for an underlying asset.
Contract adjustments: In response to a stock split, merger, or other corporate action, stock exchanges adjust the price of the contract such that the value of the position of the market participants, on the cum and ex-dates for the corporate action, shall continue to remain the same as far as possible. This will facilitate in retaining the relative status of positions viz. in-the-money, at-the-money, and out-of-money. This will also address issues related to exercise and assignments.
An options class refers to all the calls or all the puts on a given underlying security. Within a class of options, contracts share some of the same terms, such as contract size and exercise style. An options series is all contracts that have identical terms, including expiration month and strike price. For example, all XYZ calls are part of the same class, while all XYZ February 90 calls are part of the same series.
Long on option
The buyer of an option is said to be a “long on the option”. As described above, he/she would have a right and no obligation with regard to buying/ selling the underlying asset in the contract. When you are long on equity option contract:
· You have the right to exercise that option.
· Your potential loss is limited to the premium amount you paid for buying the option.
· Profit would depend on the level of underlying asset price at the time of exercise/expiry of the contract.
Short on option
The seller of an option is said to be “short on the option”. As described above, he/she would have an obligation but no right with regard to selling/buying the underlying asset in the contract. When you are short (i.e., the writer of) an equity option contract:
· Your maximum profit is the premium received.
· You can be assigned an exercised option any time during the life of the option contract (for American Options only). All option sellers should be aware that assignment is a distinct possibility.
· Your potential loss is theoretically unlimited as defined below.
Opening a Position
An opening transaction adds to or creates a new trading position. It can be either a purchase or a sale. With respect to an option transaction, we will consider both:
· Opening purchase (Long on option) – A transaction in which the purchaser’s intention is to create or increase a long position in a given series of options.
· Opening sale (Short on option) – A transaction in which the seller’s intention is to create or increase a short position in a given series of options.
Closing a position
A closing transaction reduces or eliminates an existing position by an appropriate offsetting purchase or sale. This is also known as “squaring off” your position. With respect to an option transaction:
· Closing purchase – A transaction in which the purchaser’s intention is to reduce or eliminate a short position in a given series of options. This transaction is frequently referred to as “covering” a short position.
· Closing sale – A transaction in which the seller’s intention is to reduce or eliminate a long position in a given series of options.
Note: A trader does not close out a long call position by purchasing a put (or any other similar transaction). A closing transaction for an option involves the purchase or sale of an option contract with the same terms.
Leverage
An option buyer pays a relatively small premium for market exposure in relation to the contract value. This is known as leverage. In our examples above (long call and long put), we have seen that the premium paid (Rs 8,876.25 for long call and Rs 10,612.50 for the long put) was only a small percentage of the contract value (Rs 4,65,000 in both cases). A trader can see large percentage gains from comparatively small, favorable percentage moves in the underlying equity.
Leverage also has downside implications. If the underlying price does not rise/fall as anticipated during the lifetime of the option, leverage can magnify the trader’s percentage loss. Options offer their owners a predetermined, set risk. However, if the owner’s options expire with no value, this loss can be the entire amount of the premium paid for the option. 60
| Risk | Return |
Long | Premium paid | Unlimited |
Short | Unlimited | Premium received |