OPTIONS
(Source: Kotak Securities)

What are options?

Before you begin options trading it is critical to have a clear idea of what you hope to accomplish. Only then will you be able to narrow down on an options trading strategy. Let us first understand the concept of options.

An option is part of a class of securities called derivatives.

The concept of options can be explained with this example. For instance, when you are planning to buy some property you might have placed a nonrefundable deposit to hold it for a short time while you evaluate other options. That is an example of a type of option.
Similarly, you have probably heard about Bollywood buying an option on a novel. In 'optioning the novel,' the director has bought the right to make the novel into a movie before a specified date. In both cases, with the house and the script, somebody put down some money for the right to buy a product at a specific price before a specific date.

Buying a stock option is quite similar. Options are contracts that give the holder the right to buy or sell a fixed amount of a certain stock at a specified price within a specified time. A put option gives the holder the right to sell the security, a call option gives the right to buy the security. However, this type of contract gives the holder the right, but not the obligation to trade stock at a specific price before a specific date. Several individual investors find options useful tools because they can be used either as:

A) A type of leverage or
B) A type of insurance.

Trading in options lets you benefit from a change in the price of the share without having to pay the full price of the share. They provide you with limited control over the shares of a stock with substantially less capital than would be required to buy the shares outright.
When used as insurance, options can partially protect you from the specific security's price fluctuations by granting you the right to buy or sell shares at a fixed price for a limited amount of time.

Options are inherently risky investment vehicles and are suitable only for experienced and knowledgeable investors who are prepared to closely monitor market conditions and are financially prepared to assume potentially substantial losses.

What are the different types of Options? How can Options be used as a strategic measure to make profits/reduce losses?
Options may be classified into the following types:
a) Call Option
b) Put Option

As mentioned before, there are two types of options, calls and puts. A call option gives the holder the right to buy the underlying stock at the strike price anytime before the expiration date. Generally Call options increase in value as the value of the underlying instrument increases.

By contrast, the put option gives the holder the right to sell shares of the underlying stock at the strike price on or before the expiry date. The put option gains in value as the value of the underlying instrument decreases. A put option is one where one can insure a stock against subsequent price fall. If the value of your stocks goes down, you can exercise your put option and sell it at the price level decided upon earlier. If in case the stock price moves higher, all you lose is just the premium amount that was paid.

Note that in newspaper and online quotes you will see calls abbreviated as C and puts abbreviated as P.

The examples stated below will explain the use of Put options clearly:

Case 1:

Rajesh purchases 1 lot of Infosys Technologies MAY 3000 Put and pays a premium of 250 This contract allows Rajesh to sell 100 shares of Infosys at Rs 3000 per share at any time between the current date and the end of May.Inorder to avail this privilege, all Rajesh has to do is pay a premium of Rs 25,000 (Rs 250 a share for 100 shares).

The buyer of a put has purchased a right to sell. The owner of a put option has the right to sell.

Case 2:

If you are of the opinion that a particular stock say "Ray Technologies" is currently overpriced in the month of February and hence expect that there will be price corrections in the future. However you don't want to take a chance , just in case the prices rise. So here your best option would be to take a Put option on the stock.

Lets assume the quotes for the stock are as under:

Spot Rs 1040
May Put at 1050 Rs 10
May Put at 1070 Rs 30
So you purchase 1000 "Ray Technologies" Put at strike price 1070 and Put price of Rs 30/-. You pay Rs 30,000/- as Put premium.
Your position in two different scenarios have been discussed below:

1. May Spot price of Ray Technologies = 1020
2. May Spot price of Ray Technologies = 1080
In the first situation you have the right to sell 1000 "Ray Technologies" shares at Rs 1,070/- the price of which is Rs 1020/-. By exercising the option you earn Rs (1070-1020) = Rs 50 per Put, which amounts to Rs 50,000/-. Your net income in this case is Rs (50000-30000) = Rs 20,000.

In the second price situation, the price is more in the spot market, so you will not sell at a lower price by exercising the Put. You will have to allow the Put option to expire unexercised. In the process you only lose the premium paid which is Rs 30,000.


what is open interest?

The total number of option contracts and/or futures contracts that are not closed or delivered on a particular day and hence remain to be exercised, expired or fulfilled through delivery is called open interest.

What are Index Futures?

As Stated above, Futures are derivatives where two parties agree to transact a set of financial instruments or physical commodities for future delivery at a particular price. Index futures are futures contracts where the underlying is a stock Index (Nifty or Sensex) and helps a trader to take a view on the market as a whole.

What is meant by the terms Option Premium, strike price and spot price?

The price that a person pays for a call option/Put Option is called the Option Premium. It secures the right to buy/sell that particular stock at a specified price called the strike price. In other words the strike price is the specified price at which the holder of a stock option may purchase the stock. If you decide not to use the option to buy the stock, and you are not obligated to, your only cost is the option premium. Premium of an option = Option's intrinsic value + Options time value The stated price per share for which underlying stock may be purchased (for a call) or sold (for a put) by the option holder upon exercise of the option contract is called the Strike price. Spot Price is the current price at which a particular commodity can be bought or sold at a specified time and place.

What is meant by settlement price?

The last price paid for a contract on any trading day. Settlement prices are used to determine open trade equity, margin calls and invoice prices for deliveries.

How does one determine the price of an option?

A variety of factors determine the price of an option.
The behavior of the underlying stock considerably affects the value of an option. Investors have different opinions about how a particular stock will behave in the future and hence may disagree about the value of any given option.

In addition, the value of an option decreases as its expiration date approaches. Thus, its value is also highly dependent on the amount of time left before the option expires.

Intrinsic & Time Value
An options price is composed of its intrinsic value and time value.
What a particular option 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. Intrinsic value is how far an option is 'in-the-money.' Thus, the phrase is an adjective used to describe an option with an intrinsic value. A call option is in- the-money if the spot price is above the strike price. A put option is in the money if the spot price is below the strike price.

It is calculated by subtracting the options strike price from the spot price. An out-of-the-money option has an intrinsic value of zero.

For example if XYZ is trading at Rs 58 and the June 55 call is trading at Rs 4, to calculate the intrinsic value subtract Rs 55 from 58, leaving you with Rs 3 of intrinsic value. The remaining Rs 1 is known as extrinsic or time value.

Time value is the amount over intrinsic value that a buyer pays for the option. While buying time value, an options purchaser assumes that the option will increase in value before it expires. As the option nears expiration, its time value starts decreasing toward zero.

Theoretical Value

Theoretical value is the objective value of an option. It shows how much time-value is left in an option. The most commonly used formula to calculate the theoretical value of an option is known as the Black-Scholes model.

This model considers the price of the stock, the options strike price, the time remaining before expiration, the volatility of the underlying stock, the stock's dividends and the current interest rate while arriving at the theoretical value of the option.

Although an option may trade for more or less than its theoretical value, the market views the theoretical value as the objective standard of an option's value. This makes the price of all options tilt toward their theoretical value over time.

The Components of Theoretical Value

Volatility

The volatility of the underlying stock is one of the key factors in determining the value of an option. Often, the options price increases as the volatility of the stock increases. The difficulty in predicting the behavior of a volatile stock permits the option seller to command a higher price for the additional risk.

There are two types of volatility, historical and implied. As the term suggests, historical volatility is a measurement of the stocks movement based on its past behavior.

By contrast, implied volatility is calculated using option prices. It is a measurement of the stocks movement as implied by how the market is currently valuing options.

Dividends
As an owner of a call option you can always exercise your right to the stock and receive any dividend it might pay.

Interest Rate

If you buy an option rather than a stock, you invest less money upfront.

Days Until Expiration


An option, being a wasted asset; wastes a little as each day lapses. Thus its value is calculated in accordance to the amount of days left in its life.

What are swaptions?

A swaption is an option on an interest rate swap. Swaptions are options contracts, which give you the right to enter into a swap agreement at the option expiration, in return for a one-off premium payment.

What is meant by Covered Call, Covered Put, In the Money, Out Of the Money, At the Money?

Ø In-the-money

A call option is in the money if the strike price is less than the market price of the underlying security. A put option is in-the-money if the strike price is greater than the market price of the underlying security.

Ø Out of the money

A call option is out-of-the-money if the price of the underlying instrument is lower than the exercise/strike price. A put option is out-of-the-money if the price of the underlying instrument is above the exercise/strike price.


Ø At-the-money

At the money is a condition in which the strike price of an option is equal to (or nearly equal to) the market price of the underlying security.

Ø Covered Call

You can take a covered call if you take a long position in an asset combined with a short position in a call option on the same underlying asset.

Ø Covered Put

The selling of a put option while being short for an equivalent amount in the underlying security.

About Options


An option contract goes one step beyond a futures contract, towards capping risks. These contracts give you the right but not the obligation to buy or sell shares or an index, at a specified price (strike price or exercise price), on or before a given date in future (expiration date). So, if you have purchased an option contract, you have the right to simply ignore the terms of the contract if the price of the underlying shares or index goes against you. Of course you have to pay a price, called a premium, for this privilege.

On the other side of this transaction, there is an option seller, also called the option writer. This trader gives you the right to buy or sell the underlying asset in exchange for the premium that you pay. He, himself, has no rights and is obligated to comply with the contract if you choose to exercise your option.

Remember that while the term 'writer of an option' is used to denote the seller of the option, there are no physical documents that are exchanged between the buyer and the seller of an option. All transactions are merely recorded by the stock exchange through which they are routed.

Lot Sizes

Expiration Dates

Strike Price Intervals

American and European Option

Open Interest

Lot Sizes

The lot sizes in the case of option contracts are the same as those for futures. For instance, if you want to buy an Option contract on Reliance Industries Ltd, your underlying asset is a lot of 600 shares of Reliance, just as in the case of futures. Similarly, if you want to purchase one Option contract on the Nifty 50, your contract multiplier is 100; the same as it is for a Nifty 50 futures contract.

Expiration Dates

The expiration dates for Option contracts are also standardized to match those of futures contracts. As in the case of futures contracts, there are contracts of three durations being traded simultaneously - the near month (1 month), middle month (2 months) and far/distant month (3 months). All these contracts also expire on the last Thursday of their respective contract months, after which the options are worthless. Fresh contracts with a three month duration begin trading the next business day after the last Thursday of each month, after which the 2 month contracts become 1 month contracts and the three month contracts become two month contracts.


Strike Price Intervals

Strike Price Intervals are the various levels of strike prices for each Index and Stock Options. The exchange authorities determine the strike prices. For every Option type, the exchanges provide a minimum of five strike prices during the month. Two contracts will be above the spot price (the previous days closing price), two below the spot price and the last one will be equivalent at the spot price. Although the intervals are fixed, the strike prices that are added to the existing ones that are traded keep on changing with the change in spot prices.

American and European Options

When an Option can be exercised anytime on or before it reaches its expiry date it is called an American Option. Options on stocks in India are American styled and can be exercised anytime during their life. If, on the other hand, an Option can be exercised only on the date of expiry and not before, it is called a European Option. In India, all Index options are European Option

Open Interest

Open interest comprises the total number of outstanding positions in a particular type of contract of all market participants at any given time. In other words, it is the sum of all the net long outstanding positions of all buyers of a particular type of contract.

To explain with an illustration - For every buyer of a contract, there is a corresponding seller. Let us assume that the trader A has bought 100 Nifty futures and trader B is the opposite party. Let us also assume that the brought forward volume is nil in this case and trader A and B are entering the market for the first time. In this case, the open interest would be 100 futures or one contract. Let us assume the price rises on the next day and trader A sells his futures to say trader C. Here, the open interest would not increase since the new position created by trader C would be offset by the reduction of an existing position of trader A. However, in the event of trader A buying another 100 shares from say trader D, who has short sold, the open position would increase by 100 futures or one contract, since none of the parties are offsetting their existing positions.

All open interest would become nil at the expiry date of the contract for the particular series. For instance, open interest in July futures would be nil after the last Thursday of the month of July. However, open interest for the contracts of August and September would still continue till their expiry dates in August and September, respectively.

An analogy of an Option

To explain an option on a lighter note, let's say you book tickets for a particular movie in advance. You have bought the right to view the movie but are not under any obligation to do so. You could either exercise your right to view the movie on the appointed date at the appointed time or you simply sell off your tickets, for a higher or lower price, depending on the demand for the movie. Lastly, you may just decide to let your tickets go waste and not show up for the show at all. On the flip side, the person who sells an option can be compared to the theatre owners. Once they have sold movie tickets to you, they are obliged to show you the movie. This is broadly how options in the capital market work too, but at a slightly more complex level since there are a variety of options available, which are suitable for different market conditions and can be chosen on the basis of your expectations and risk profile.

Call and Put Options

On the basis of whether you want the option to buy shares or sell them at a specific price in the future, there are two types of options available in the derivatives markets. They are called the 'Call option' and the 'Put option'. The former gives you the right to buy shares or an index whereas the latter gives you the right to sell them, with no obligation. Let's take a look at these two options, one at a time.

Call Option

When you purchase a 'call option', you purchase the right to buy a certain number of shares or an index, at a predetermined price (strike or exercise price), on or before a specific date in the future (expiry date). In exchange for this facility, you have to pay an option premium to the seller/writer of the option. This is because the writer of the option assumes the risk that the market price will rise beyond your strike price on or before the expiry date of your contract and he will be obliged to sell you shares at the strike price, although it means making a loss. The premium payable is a small amount that is also market driven.

Illustration of a Call Option on an index

As a trader, you would choose to purchase an index Option if you have a view on the price movement of the index rather than any expectation about the price movement of a particular share. Indices on which you can trade include the S&P Nifty CNX 50, CNX IT and Bank Nifty on the NSE and the Sensex on the BSE.

Suppose the Nifty is quoting around 3000 points today. If you are bullish about the market and foresee this index reaching the 3100 mark within the next one month, you may buy a one month Nifty call at 3100. Let's say that this call is available at a premium of Rs 30 per share. Since the current contract size of the Nifty is 100 units, you will have to pay a total premium of Rs 3000 to purchase one Call Option on the index. If the index remains below 3100 points for the whole of the next month, until the contract expires, you would certainly not want to purchase it at 3100 levels. And you have no obligation to purchase it either. You could simply ignore the contract and all you have lost is your premium of Rs 3000.

If, on the other hand, the index does cross 3100 points, as you expected, you have the right to buy at 3100 levels. Naturally, you would like to exercise your call option. But remember that you will start making profits only once the Nifty crosses 3130 levels, since you must add the cost that you have incurred by paying the premium to the cost of the index. This is called your break even point a point where you make no profits and no losses. When the index is anywhere between 3100 and 3130 points, you begin to recover your premium cost, so it still makes sense to exercise your option at these levels, if you do not expect the index to rise further or the contract reaches its expiry date at these levels.


Now, let's look at how the writer of this Option is fairing. As long as the index does not cross 3100 and you do not exercise the option, he benefits from the Option premium that he has received from you. If you exercise your Option when the index is between 3100 and 3130, he is forced to part with some of the premium that you have paid him. Once the index is above 3130 and you exercise your Option, his losses are equal in proportion to your gains and both depend upon how much the index rises.

In a nutshell, the option writer has taken on the risk of a rise in the index for a sum of Rs 30 per share. Further, while your losses are limited to the premium that you pay and your profit potential is unlimited, the writer's profits are limited to the premium and his losses could be unlimited.

Illustration of a Call Option on a stock
In the Indian market, Options cannot be sold or purchased on any and every stock. SEBI has permitted Options trading on only certain stocks that meet its stringent criteria. These stocks are chosen from amongst the top 500 stocks in terms of average daily market capitalisation and average daily traded value in the previous six months on a rolling basis, amongst other technical criteria.

Suppose the AGM of RIL is due to be held shortly and you believe that an important announcement will be made at the AGM. While the share is currently quoting at Rs 950, you feel that this announcement will drive the price upwards, beyond Rs 950. However, you are reluctant to purchase Reliance in the cash market as it involves too large an investment and you would rather not purchase it in the futures market as futures leave you open to an unlimited risk, in case the market goes against you. Yet you do not want to lose the opportunity to benefit from this rise in price due to the announcement and you are ready to stake a small sum of money to rid yourself of the uncertainty. An Option is ideal for you. Depending on what is available in the Options market, you may be able to buy a Call Option of Reliance at a strike price of 970, although the spot price is Rs 950 at present, by paying a premium of Rs 10 per share. The total premium that you will have to pay is Rs 6,000, since one contract of Reliance consists of 600 shares.


You start making profits once the price of Reliance in the cash market crosses Rs 980 per share (i.e., your strike price of Rs 970 + premium paid of Rs 10).

Now let's take a look at how your investment performs under various scenarios. If the AGM does not result in any spectacular announcements and the share price remains static at Rs 950 or drifts lower to Rs 930 because market players are disappointed, you could allow the Call Option on Reliance to lapse. In this case, your loss would be Rs 10 per share, amounting to a total of Rs 6,000. However, things could have been worse if you had purchased the same shares in the cash market or in the futures segment. On the other hand, if the company makes an important announcement, it would result in a good amount of buying and the share price may move to Rs 1,000. You would stand to gain Rs 20 per share, i.e., Rs 1,000 less Rs 980 (strike price of Rs 970 + premium of Rs 10), which was your cost per share.

As in the case of the index Call Option, the writer of this Options would stand to gain only when you lose and vice versa, and to the same extent as your gain/loss.

Payments/margins involved in buying and selling call options


Buying options

When you buy an option contract, you pay only the premium for the option and not the full price of the contract. The premium is payable to the broker based on the contract issued to you at the end of the day. Your broker then passes on this premium to the exchange on the next working day. Then exchange pays this premium to the broker of the seller of the option, who in turn passes it on to his client.

Selling options


Remember, while the buyer of an option has a liability that is limited to the premium that he must pay, the seller has a limited gain but his potential losses are unlimited. Therefore, the seller of an option has to deposit a margin with the exchange, via his broker, as security in case of an adverse movement in the price of the options that he has sold. The margins are levied on the contract value and the amount (in percentage terms) that the seller has to deposit is dictated by the exchange. This amount typically ranges from 15 per cent to as high as 60 per cent in times of extreme volatility. So, the seller of a call option of Reliance at a strike price of 970, who receives a premium of Rs 10 per share would have to deposit a margin of Rs 1,16,400, assuming a margin of 20 per cent (20 per cent of 970 x 600), although the value of his outstanding position is Rs 5,82,000.

Settling a Call Option


When you sell or purchase an Index Option, since these are European style Options, you can either exit your position before the expiry date, through an offsetting trade in the market, or hold your position open until the Option expires. Subsequently, the clearing house settles the trade. In the case of Stock Options, since these are American style Options, you can either sell your long positions or buy back your short positions before the expiry of the contract or exercise your Option anytime on or before the expiry date of the contract.

For a buyer of a Call Option

If you decide to square off your position before the expiry of the contract, you will have to sell the same number of Call Options that you have purchased, of the same underlying stock and maturity date. If you have purchased 2 Options (lot size 500) at a strike price of Rs 100, on XYZ Ltd. which expire at the end of March, you will have to sell the above 2 Options (strike price Rs 100, expiry end-March) of XYZ Ltd., in order to square off your position. When you square off your position by selling your Options in the market, as the seller of an Option, you will earn a premium. The difference between the premium at which you bought the Options and the premium at which you sold them will be your profit or loss. In case you exercise your Option on or before the expiration date, the stock exchange will calculate the profit/loss on your positions. This is basically the difference between closing market price on the day you exercise the Option and the strike price. Your account will be credited or debited for the amount of your profit or loss. However, your maximum loss will be restricted to the premium paid.

For the seller of a Call Option

If you have sold Call Options and want to square off your position, you will have to buy back the same number of Call Options that you have written and these must be identical in terms of the underlying scrip and maturity date to the ones that you have sold. In case the Option gets exercised on or before the expiration date, the stock exchange will calculate the profit/loss on your position, based on the difference between the strike price and the closing market price on the day that the Option is exercised and you will have to bear the losses, if any. These will be adjusted against the margin that you have provided to the exchange and the balance margin will be credited to your account with the broker.

Put Option


When you purchase a 'Put Option’ it gives you the right to sell the underlying stock or index at a pre-determined price (strike price/exercise price) on or before a specified date in the future (expiry date).

In a number of ways, a 'Put' is similar to a 'Call' Option. Just as in the case of a Call Option:

A strike price and expiry date are predetermined by the stock exchange.

The buyer of a Put Option places a buy order, through his broker, for an Option that is available in the market, specifying the strike price and the expiry date and how much he is ready to pay for the Option.

The buyer of the Put Option must pay a premium, which is passed on to the seller by the exchange.

The seller must maintain margins with his broker.

The buyer of a Put Option can exercise his Option to sell the shares on or before the expiry date in the case of Stock Options and only on the expiry date in case of index Options.

The buyer could also sell off the Put Option to another buyer before the expiry date and receive a premium.

However, the major difference between a Call and a Put Option is that a Put Option is used when market conditions and expectations are diametrically opposite to those that call for a Call Option. Let's take a look.

Illustration of a Put Option on an index

Suppose the Nifty is currently 3000 points and you feel bearish about the market and expect the Nifty to fall from its present levels to around 2900 levels within a month. To make the most of your view of the market, you could purchase a 1-month put Option with a strike price of 2950. If the premium for this contract is Rs 10 per share, you will have to pay up Rs 1,000 for the Nifty Put Option (100 units x Rs 10 per unit).

Let's see what outcomes you and the seller of the Option derive from this transaction under various market conditions.

Illustration of a Put Option on stocks

Put Options on stocks also work the same way as Call Options on stocks. However, the Option buyer is bearish about the price of a stock and hopes to profit from a fall in its price. Getting back to the example of Reliance shares, assume that bad news is expected at the AGM and you believe the price of Reliance will fall from its current level of Rs 950 per share. To make the most of a fall in the price, you could buy a Put Option on Reliance, at the strike price of Rs 930 at a market determined premium of say Rs 10 per share. You would have to pay Rs 6,000 as premium (600 shares x Rs 10 per share) to purchase one Put Option on Reliance. Here’s what you and the seller of the option derive from this transaction under various market conditions.


Covered Options and Naked Options

Now, you may have noticed that while the buyer of the Option has limited scope for losses, he could make unlimited profits, if the market moves strongly in his favour. The seller of an Option, on the other hand, only stands to benefit from the premium that he receives but could lose considerably, if the market moves against him. So, does this mean that an Option seller must necessarily be an intrepid speculator? Not really. You could sell call Options in order to hedge your investments or reduce the cost of your investments. However, the difference is that you must actually hold the underlying shares of the calls that you sell. These are called 'covered call' Options.


Reducing the price of existing shares

Suppose you actually hold 600 share of Reliance in your demat account. If you do not expect any major movements in the price of Reliance in the cash market and wish to reduce the cost of these shares, you could sell a Call Option to the extent of the shares that you hold. This becomes a covered call. Here's how it works. If you do not expect the price of Reliance to go beyond Rs 950 per share, you may sell a Reliance call at a strike price of Rs 950 for a premium of Rs 20. You will receive a total premium of Rs 12,000 (Rs 20 x 600 shares).

If all goes well and the price does not increase above Rs 950, your shares are safe with you and the premium that you receive goes towards reducing the cost of the shares that you hold by Rs 20 each. However, if the price does go above Rs 950, you always have your shares to fall back on. You could sell off your shares to settle off the buyer of the call. It is assumed that you will have chosen a strike price that is above the cost at which your purchased the shares so that in case the Option is exercised, you do not make an actual loss, only a notional one. This is because you are not able to benefit from selling your shares at a price that is higher than the strike price, although the market has crossed that level.

You could also use the covered call strategy to limit the risk of an open position that you have in the futures market, by likening your long futures position to the long cash market position explained in the covered call illustration above.

Simply Speculating

A Covered Call could also benefit a speculator who does not want to take undue risks but merely make the most of a bearish expectation from the price of an underlying share or index. Let's say that you expect the price of Reliance to fall. You could purchase a Put Option to benefit from this situation, but that would mean that you have to pay a premium. So, instead, you may decide to sell a Reliance Call Option and receive a premium. If the price of Reliance moves in your favour (i.e., actually falls), the Call will not be exercised. But if it rises beyond the strike price, you could use the shares that you hold to settle off the buyer of the Call.

Naked Calls or Puts

When you sell a Naked Call or Put Option, you have no underlying assets or open position in the futures market to protect you from an unlimited loss, if the market goes against you. These types of Options are sold by speculators who feel very strongly about the direction of an index or the price of a stock. And, if the market does go against them, they may try to salvage the situation by offsetting their Option sale by purchasing identical Options or they may consider taking up a position in the futures market that will nullify the losses made through selling a Naked Call or Put.

Options Pricing

So far, you have come to understand that the price that you pay to purchase an Option is called the premium. You also know that it is a small fixed amount and that it is market driven. Now let's look a little deeper at how this premium is arrived at in the market and the science beneath it. However, before that, you must familiarize yourself with certain terms, which will facilitate a better understanding of pricing of Options.

In-the-money, out-of-the-money and at-the-money

Intrinsic Value and Time Value

Combined effect of the Intrinsic Value and Time Value

In-the-money, out-of-the-money and at-the-money


Irrespective of whether you buy a call or a Put Option, you will find yourself in one of three situations - in-the-money, out-of-the-money or at-the-money. A Call Option is said to be in-the-money, if the price of the stock in the cash market is greater than the strike price, i.e., you could make money by executing the Option. If the strike price is higher than the spot price of the share, the call is said to be out-of-the-money, i.e., you will not make money by exercising the Option. However, if the stock price matches the strike price, the call is said to be at-the-money.

In the case of a Put Option, things are the other way around. When the strike price is greater than the spot price, you are in-the-money, since this is a situation that could be profitable to you. If the strike price is lower than the spot price, you are out-of-the-money (no scope for profit) and when the two are equal, you are at-the-money.


Intrinsic Value and Time Value

An Option premium is the sum of two components. These are the 'intrinsic value' and the 'time value'. Option price = Intrinsic value of the Option + Time value of the Option.

The Intrinsic Value

is the difference between the cash market spot price and the strike price and is considered to be either positive (if you are in-the-money) or zero (if you are either at-the-money or out-of-the-money). Putting it simply, if a contract is in-the-money, it offers some value to a prospective buyer but if it is at-the-money or out-of-the-money, the buyer sees no sense in buying it; as a result, it has no value, i.e., its value is zero. There is no question of an Option having a negative intrinsic value.

The Time Value

of an Option contract is directly dependent on the time left between the current date and the expiry date of the contract, i.e., the time to expiry. The greater the time to expiry, the higher will be the time value in any contract. This is because at the beginning of the contract month, the buyer of the option has more time during which he can exercise or offset an Option. In comparison, Options that are nearer expiry allow a buyer less leeway to wriggle out of a tricky situation. It is the extra time and therefore lower risk, that gives a contract with a longer time to expiry a higher time value.


Combined Effect of the Intrinsic Value and Time Value

At the beginning of a contract period, an Option may fetch a slightly higher price than it will later on, due to the time value. However, as time elapses and the expiry date approaches, the value of an Option diminishes, all other factors being constant. Side by side, an Option will always fetch an intrinsic value, as long as it remains in-the-money till the expiry date. If it goes out-of-the-money or stays at-the-money, the Option may not have any intrinsic value but its time value remains and diminishes as the expiry date draws near.

This is best explained with a couple of examples.

Intrinsic and Time value in case of Call Option

Intrinsic and Time value in case of Put Option

Other factors that affect the Option premium

While Option premiums are largely a function of the strike price, spot price and the time to expiry, there are other major factors that affect the pricing of an Option. These are volatility (ups and downs in the price of the underlying stock), interest rate and dividends, if any, between the current date and the expiry date. There are advanced models like the Black and Scholes' model, which try to determine the price of an Option on the basis of a number of variables. These models also enable a trader to track the changes in pricing of Options as the parameters and variables used in the model change.

Difference between Futures and Options

An Option gives the buyer the right but not the obligation while the seller has an obligation to comply with the contract. In the case of a futures contract, there is an obligation on the part of both the buyer and the seller. When you purchase call or put Options you have the right to let your Option lapse but if you choose to exercise it, the counter-party (seller) must comply. A futures contract, on the other hand, is binding on both counter-parties as both parties have to settle on or before the expiry date.

Purchasing a futures contract requires an up front margin and normally involves a larger outflow of cash than in the case of Options, which require only the payment of premium.

A futures contract carries unlimited profit and loss potential whereas the buyer of a Call or Put Option's loss is limited but the profit potential is unlimited.

Futures are a favourite with speculators and arbitrageurs whereas Options are widely used by hedgers.

Option Trading Strategies

While Option contracts offer immense trading possibilities since these products can be used in tandem with stock futures or equity shares for the construction of various derivative strategies. A thorough understanding of how options can be used is the basis for further improvisation. Here are some commonly used strategies that deal with options alone.

Strategy Scenario: High bullishness
Action: Buy an out-of-the-money call option

Assumptions

Underlying Stock: Reliance Industries Ltd.
Current cash market price: Rs 1,060
Contract size: 600 shares
Strike prices available: Rs 1,060, Rs 1,080, Rs 1,100, Rs 1,140.
Premium: Rs 41, Rs 31, Rs 21, Rs 12, respectively, for the above strike prices.


If you are bullish about Reliance and expect the price to go beyond Rs 1,150, you could buy a call with a strike price of Rs 1,100, which is available at a premium of Rs 21. The payoff would start once the share price exceeds Rs 1,121. You stand to lose Rs 12,600 (600 x 21) if the share price remains below Rs 1,100 until the expiry date.


Strategy Scenario: Sluggishness or a possible fall in price
Action: Sell an at-the-money naked call


Assumptions


Underlying Stock: Reliance Industries Ltd.
Current cash market price: Rs 1,060
Contract size: 600 shares
Strike prices available: Rs 1,060, Rs 1,050, Rs 1,040
Premium: Rs 41, Rs 48, Rs 53, respectively, for the above strike prices.


If you do not envisage any major movement, i.e., a listless market, then you may use this opportunity to sell a call option at the current rate. You need to short a call option at a strike price of Rs 1,060 for which you will receive a premium of Rs 41. This will yield you a short gain of Rs 24,600, if the market remains static at the current levels. The payoff is immediate and you will be affected only beyond the price level of Rs 1,101 (1060+41). You do not stand to lose till such time the price of Reliance exceeds Rs 1,101. Beyond that, every rise of Re 1 in the price of Reliance will cost you Rs 600 (since the lot size is 600 shares).


Strategy Scenario:

Possible sharp fall in the price of a stock or index
Action: Buy a put option at a high out-of-the-money level

Assumptions


Underlying Stock: Reliance Industries Ltd.
Current cash market price: Rs 1,060
Contract size: 600 shares
Strike prices available: Rs 1,040, Rs 1,020, Rs 1,000
Premium: Rs 33, Rs 26, Rs 22, respectively, for the above strike prices .


If you have a bearish view, you could buy a put option with a strike price of Rs 1,000 for a premium of Rs 22. This will involve a payment of Rs 13,200. If the price of Reliance falls below Rs 1,000, the above strategy would yield a gain of Rs 600 per fall of Re 1 in the price and you stand to lose a sum of Rs 13,200, if the share price of Reliance does not fall below Rs 1,000.


Strategy Scenario: Sluggishness or a possible rise
Action: Sell an at-the-money put option (naked put)

Assumptions


Underlying Stock: Reliance Industries Ltd.
Current cash market price: Rs 1,060
Contract size: 600 shares
Strike prices available: Rs 1,020, Rs 1,040, Rs 1,050.
Premium: Rs 26, Rs 33, Rs 36, respectively, for above strike prices.


If you do not expect any major movement in the price or at the most, a possible rise, then you could use this opportunity to sell a put option at the current rate. You may short a put option for a strike price of Rs 1,050 and receive a premium of Rs 36 per share. This will yield a short gain of Rs 21,600 if the market remains static at the current levels or rises subsequently. The payoff is immediate and you would be affected only beyond the price level of Rs 1,014 (Rs 1,050 - Rs 36). You do not stand to lose till such time the price of Reliance stays above Rs 1,014. However, beyond that you lose at Rs 600 per fall of Re 1 in the price of Reliance.


Spreads


Strategy Scenario: Moderate bullishness
Action: Bull Spread using call options


A bull spread is created by buying a call option and simultaneously selling a call option while ensuring that the strike price of the purchased call is lower than the strike price of the call that you sell. A bull spread can also be constructed by buying a put option and selling another. Here again, the strike price of the purchased put must be lower than the strike price of the put that you sell.

Assumptions


Underlying Stock: Reliance Industries Ltd.
Current cash market price: Rs 1,060
Contract size: 600 shares

Strike prices available for call option: Rs 1,060, Rs 1,080, Rs 1,100.
Premium: Rs 41, Rs 31, Rs 21, respectively, for the above strike prices.

If you are moderately bullish on Reliance and foresee the price of Reliance going beyond Rs 1,100, you could buy a call with a strike price of Rs 1,060, which is available at a premium of Rs 41, and simultaneously sell a call option with a strike price of Rs 1,100, which would fetch you Rs 21 per share. The net cost of the spread would be Rs 41 less Rs 21, i.e., Rs 12,000 (for a lot size of 600 shares). If the price of Reliance stays below Rs 1,060, you will stand to lose Rs 12,000 and neither of the calls will be executed. The break even point for this spread position is at Rs 1080, which is the lower strike price plus the net premium payable, i.e. Rs 1,060 + Rs 20. But what if the price remains above Rs 1,060 but below Rs 1,080 or what if the price exceeds Rs 1,080. The different payoffs for each scenario are illustrated below. However, here you have capped your selling price at Rs 1,100 and would not be able to take advantage of any gain that could accrue, if the share price exceeds Rs 1,100.


Strategy Scenario: Moderate bearishness
Action: Bear Spread using call options


In contrast to a bull spread, a bear spread is used when one is bearish about the market. A bear spread can be created by selling a call option of a lower strike price and simultaneously buying a call option of a higher strike price. Alternatively, you could create a bear spread by selling a put option of a lower strike price and simultaneously buying a put option of a higher strike price. Irrespective of whether you use calls or puts, the option that you purchase in a bear spread should have a higher strike price than the one that you sell.

The bear spread strategy explained here uses call options.

Assumptions


Underlying Stock: Reliance Industries Ltd.
Current cash market price: Rs 1,060
Contract size: 600 shares
Strike prices available: Rs 1,060, Rs 1,080, Rs 1,100.
Premium: Rs 41, Rs 31, Rs 21, respectively, for the above strike prices.


If you are moderately bearish on Reliance and expect the price of Reliance to fall, you could sell a call option with a strike price of Rs 1,060 and receive a premium of Rs 41 per share and simultaneously buy a call option with a strike price of Rs 1,100 at the rate of Rs 21 per share. The net inflow would be Rs 12,000 (Rs 41 less Rs 21 multiplied by 600). For any market price below Rs 1,060 both the options would expire worthless and the total profit on the position would be the net premium received at Rs 20 per share. Here, the break-even price would be at a market price that equals the lower strike price plus the net premium received, i.e., Rs 1,080 (Rs 1,060 + Rs 20). At the higher strike price, both options would get exercised but your loss will be limited to Rs 12,000 since the profit from the long call offsets the losses from the short call to an extent.


Strategy Scenario: Uncertainty in price movements and expected movement in either direction will be large.
Action: Long Strangle.
Simultaneously buying a call option and a put option and ensuring that the strike price of the call option is higher than the strike price of the put option.

This strategy is generally used when company results are due or election results are expected.

Assumptions


Underlying Stock: Reliance Industries Ltd.
Current cash market price: Rs 1,060
Contract size: 600 shares
Strike prices available for call option: Rs 1,060, Rs 1,080, Rs 1,100.
Strike prices available for put option: Rs 1,020, Rs 1,000.
Premium: Rs 26, Rs 22, respectively, for above put options


If you are expecting large movements in the price of a particular stock or index which may be triggered by an announcement of the outcome of an event, you could use a long strangle strategy, which involves simultaneously buying a call option and a put option wherein the strike price of the call option is higher than that of the put. You stand to benefit if the price movements are outside the boundary of the call and put option and the difference is more than the cost of buying the call and the put option. In

our example, you buy a call option with a strike price of Rs 1,100 for a premium of Rs 21 per share and buy a put option with a strike price of Rs 1,000 for a premium of Rs 22 per share. The total outflow as a result of premium payments will be Rs 21 plus Rs 22, i.e., Rs 43 per share. You will benefit if the share price shoots up above Rs 1143 (i.e., the higher strike price + the premium paid) or dips to below Rs 957 (i.e., the lower strike price + the total premium paid). The payoff from a strangle is given in the table hereunder.profit from the long call offsets the losses from the short call to an extent.


Strategy Scenario: Uncertainty in price movements but movement in either direction will be large
Action: Long Straddle.


Simultaneously purchasing a call option and a put option, with the same strike price.

This strategy is also used when company results are due or election results are expected. However, a straddle differs from a strangle in that the strike price of both the call and the put are the same, whereas in the case of a strangle, the strike price of the call option is higher than the strike price of the put option.

Assumptions

Underlying Stock: Reliance Industries Ltd.
Current cash market price: Rs 1060
Contract size: 600 shares
Strike prices available for call option: Rs 1,050

Strike prices available for put option: Rs 1,050

Premium: Rs 48 for the above call option
Premium: Rs 36 for the above put option


If you are expecting a large movement in the price of a stock or an index due to some forthcoming announcement, you could use the long straddle strategy to make the most of these movements. This strategy involves buying a call and a put option with the same strike price and the same expiry date. In the case of our example, you will buy a call option with a strike price of Rs 1,050 per share and pay a premium of Rs 48 per share. You must also buy a put option with a strike price of Rs 1,050 for a premium of Rs 36 per share. Your total outflow on account of premium in this case would be Rs 48 plus Rs 36, i.e., Rs 84 per share. You will benefit from this strategy if the share price climbs to above Rs 1134 (i.e., the strike price + the premium paid) or falls below Rs 966 (i.e., the strike price + the total premium paid). The payoff from this straddle is given in the table hereunder.


Strategy Scenario: Large price changes are unlikely.

Action: Butterfly Spreads


Assumptions


Underlying Stock: Reliance Industries Ltd.
Current cash market price:Rs 1,060
Contract size: 600 shares
Strike prices available for call option: Rs 1,040, Rs 1,050, Rs 1,060
Premium: Rs 53, Rs 45, Rs 41, respectively, for the above call options



Bull and bear spreads involve taking positions in two options. Butterfly spreads involve taking positions in options with three different strike prices. It involves buying a call at the lower strike price, a call at the highest strike price and selling two options at a strike that is between the strike prices of the two calls that you have bought (strike price between the lower strike and the higher strike price). In the example, you would buy two calls, one with a strike price of Rs 1,040 and the other with a strike price of Rs 1,060 and, simultaneously, you would sell two call options, both at a strike price of Rs 1,050. Taking into account the premiums that you have to pay and those that you receive for these four options, your net premium payable would be Rs 4 (i.e., Rs 45 + Rs 45 - Rs 53 - Rs 41). The median strike price is generally close to the spot price of the underlying shares as possible. If the stock price remains close to the median price (in this case Rs 1,050), it would result in profits. If it extends either above Rs 1056 (i.e., the highest strike price - net premiums, in this case Rs 1,060 - Rs 4) or below Rs 1044 (i.e., the lowest strike price + net premiums, in this case Rs 1,040 + Rs 4), you would make a loss. The payoff from a butterfly spread is given in the table hereunder.


Strategy Scenario: Large price changes may take place with more likelihood of increase in stock price than decrease.
Action: Straps

Assumptions


Underlying Stock: Reliance Industries Ltd.
Current cash market price: Rs 1,060
Contract size: 600 shares
Strike prices available for call option: Rs 1,050
Strike price available for put option: Rs 1,050
Premium: Rs 48 for the call and Rs 36 for the put



In a strap, you are expecting the call option to be more profitable than the put option. This strategy involves buying one put option and buying two call options with the same strike price. The payoff from a strap spread is more profitable if there is a big difference between the strike price and the spot price on the expiry date due to an increase in the spot price.

Tax aspects on derivatives

There are two types of taxes that are applicable to derivative transactions in the Indian capital markets.

~ Securities Transaction Tax (STT) is levied on all trades that result in a sale in the derivatives segment of a recognized stock exchange. Effective June 01, 2006, such transactions (both futures and options) attract STT at the rate of 0.017% of the value of the sell transaction. Additionally Service Tax is applicable @ 12.24% brokerage.

~ Since 2006-07, income from derivative transactions is treated as business income.