As we have seen earlier that an option is a contract, which gives the option buyer (holder) the right, but not the obligation, to buy or sell specified quantity of the underlying assets, at a specific (strike) price on or before a specified time (expiration date). The underlying may be physical commodities like wheat/ rice/ cotton/ gold/ oil or financial instruments like equity stocks/ stock index/ bonds etc.
SEBI has permitted option trading in Indian Capital Market Securities in the year 2001, both by way of trading in stock options and also Index Options. Options are currently traded on the Bombay Stock Exchange (BSE) and National Stock Exchange (NSE). Like trading in stocks, options trading is regulated by SEBI. These exchanges seek to provide competitive, liquid, and orderly markets for the purchase and sale of standardized options.
Options are an important element of investing in markets, serving a function of managing risk and generating income. Unlike most other types of investments today, options provide a unique set of benefits. Not only does option trading provide a cheap and effective means of hedging one's portfolio against adverse and unexpected price fluctuations, but it also offers a tremendous speculative dimension to trading.
Types of Investors who Prefer Trading in Options
Investors belonging to the following categories, depending on their financial goals and investment objectives generally consider trading in options.
Investors who want to participate in the market without trading or holding a large stock portfolio.
Investors who have strong views on the market and its future movement and want to take advantage of the same
Investors who are following the equities market very closely, and
Investors who want to protect the value of their diversified equities portfolio.
Option Contract Illustrated
An option gives you the right to buy or sell an asset at a future date. This can be done at the price specified in the option contract. But you need to use it only if the option contract price is favourable to you. If the price trend is unfavourable, you need not exercise the option. Instead you can go and buy or sell the asset in the market at a price better than the option contract price. This means an option holder has a right but not the obligation to exercise the contract. But this facility comes with a price; options help you benefit from the contract price if there are unfavourable movements asset prices in the market.
On March 1, 2003, 'A' sells a call option (right to buy) on "INFOSYS." to 'B' for a price of say Rs.300. Now 'B' has the right to approach 'A' on March 31, 2003 and buy 1 share of "INFOSYS" at Rs.5000. Here -
'B' does not have to necessarily buy 1 share of "INFOSYS." on March 31,2004 at Rs.5000 from 'A'. 'B' may find it worthwhile to exercise his right to buy only if "INFOSYS Ltd." trades above Rs.5000. If "B" exercises his option, A has to necessarily sell "B" one share of "INFOSYS." at Rs.5000 on March 31, 2003. So if the price of "INFOSYS" goes above Rs.5000 'B' may exercise his option, or else the option may lapse. Then 'B' loses the original option price of Rs.300 and 'A' has gained it.
Basic Terms Used in Option Trading Explained
Option Premium (or Option Price)
In the above transaction Rs.300 is called the Option Price or Option Premium. In the trading of options, the holder (buyer) of the options is enjoying the right to buy/sell while the writer (seller) is obliged to sell/buy depending on the action of the holder. The buyer is supposed to pay the price to buy the right to buy/sell to the seller of the options. This price is known as the option premium.
The premiums are not fixed by the Exchange and are subject to fluctuations in response to market and economic forces. The factors affecting pricing of an option include:
Current value of the underlying.
The exercise price.
Current values of futures on the underlying.
Style of option, individual opinion.
Estimates of the future volatility of the underlying.
Historical volatility of the underlying.
The time remaining till expiration.
Cash dividends payable on the underlying stock.
Current interest rates.
Depth of the market.
Available information.
Excercise Price or Strike Price
Rs.5000 is the Exercise Price or Strike Price in the above illustration. The strike or exercise price of an option is the specified/ pre-determined price of the underlying asset at which the same can be bought or sold if the option buyer exercises his right to buy/ sell on or before the expiration day.
The `strike price' is the price at which an option can be exercised. For instance, assume that you hold an European Option on INFOSYS company for one share. The strike price is fixed at Rs 5,000 and the expiration date is 31st March 2003. If the prevailing market price is say Rs 5,500, then you can exercise your option on the 31st March and buy one share of INFOSYS for Rs 5,000.
Expiration Date
In illustration referred above March 31, 2003 is the Expiration Date i.e. the date on which the option expires . Options quoted in exchange include the date and the month on which the option can be exercised. This is called the expiration date. In the case of the European option, the investor can exercise his right on the specified `expiration date' only. In the case of an American Option, investors can exercise the option on or before the `expiration date'. On Expiration date, either the option is exercised or it expires worthless
Underlying
Share of "INFOSYS" is the Underlying in the illustration above. Underlying is the specific security / asset on which an options contract is based.
Contract Cycle
The period over which a contract trades. The futures and option contracts at NSE have one month, two-months and three months expiry cycles. The contracts expire on the last Thursday of the corresponding month.
Exercise Date
means the date on which the option is actually exercised. In case of European Options the exercise date is same as the expiration date while in case of American Options, the options contract may be exercised any day between the purchase of the contract & its expiration date
(see European/ American Option)
Basis
Basis is defined as the future price minus the spot price. In most of the times basis shall be positive, which reflects that futures price normally exceeds spot price
Assignment
When holder of an option exercises his right to buy/ sell, a randomly selected option seller is assigned the obligation to honor the underlying contract, and this process is termed as Assignment.
Covered & Naked Calls
A call option position that is covered by an opposite position in the underlying instrument (for example shares, commodities etc), is called a covered call. Writing covered calls involves writing call options when the shares that might have to be delivered (if option holder exercises his right to buy), are already owned. E.g. A writer writes a call on Reliance and at the same time holds shares of Reliance so that if the call is exercised by the buyer, he can deliver the stock.
Covered calls are far less risky than naked calls (where there is no opposite position in the underlying), since the worst that can happen is that the investor is required to sell shares already owned at below their market value. When a physical delivery uncovered/ naked call is assigned an exercise, the writer will have to purchase the underlying asset to meet his call obligation and his loss will be the excess of the purchase price over the exercise price of the call reduced by the premium received for writing the call.
Intrinsic Value of an Option
The intrinsic value of an option is defined as the amount by which an option is in-the-money, or the immediate exercise value of the option when the underlying position is marked-to-market.
The intrinsic value of an option must be a positive number or 0. It can't be negative. For a call option, the strike price must be less than the price of the underlying asset for the call to have an intrinsic value greater than 0. For a put option, the strike price must be greater than the underlying asset price for it to have intrinsic value.
Time Value with Reference to Options
Time value is the amount option buyers are willing to pay for the possibility that the option may become profitable prior to expiration due to favorable change in the price of the underlying. An option loses its time value as its expiration date nears. At expiration an option is worth only its intrinsic value. Time value cannot be negative.
Open Interest
The total number of options contracts outstanding in the market at any given point of time.
Option Holder
is the one who buys an option which can be a call or a put option. He enjoys the right to buy or sell the underlying asset at a specified price on or before specified time. His upside potential is unlimited while losses are limited to the Premium paid by him to the option writer.
Option Class
All listed options of a particular type (i.e., call or put) on a particular underlying instrument, e.g., all Sensex Call Options (or) all Sensex Put Options, assuming Sensex options are traded
Option Series
An option series consists of all the options of a given class with the same expiration date and strike price. E.g. BSXCMAY3600 is an options series which includes all Sensex Call options that are traded with Strike Price of 3600 & Expiry in May.
(BSX Stands for BSE Sensex (underlying index), C is for Call Option , May is expiry date & strike Price is 3600)
Options Settled by Delivery:
This gives the owner the right to receive delivery (if it is a call) or to make the delivery (if it is a put), of the underlying when the option is exercised.
Cash-Settled Options:
This gives the owner the right to receive a cash payment based on the difference between a determined value of the underlying at the time of exercise and the fixed exercise price of the option. Nifty options shall be cash settled.
Example: You bought Nifty November call at a strike price of 1,400. On expiration of November options, the expiration level was 1,430. The cash settlement will be Rs 30 per Nifty and for one contract, Rs 6000 (that is, 30 x 200, is the minimum contract size.)
Call Option & Put Option
Options are classified into two types:
Call Option:
A call option gives the holder the right but not the obligation to buy the underlying asset at a specified exercise price. Since the initial cash flow to buy the option is comparatively small, investors bullish on the asset (can be a stock or any other asset for that matter) can use call options to maximise their returns by buying into the product. Further, even in the case of the asset moving the other way, the maximum loss for the investor is only the premium he has paid.
Example: An investor buys One European call option on Infosys at the strike price of Rs. 5000 at a premium of Rs. 300. If the market price of Infosys on the day of expiry is more than Rs. 5000, the option will be exercised. The investor will earn profits once the share price crosses Rs. 5300 (Strike Price + Premium i.e. 5000+300). Suppose stock price is Rs. 5800, the option will be exercised and the investor will buy 1 share of Infosys from the seller of the option at Rs 5000 and sell it in the market at Rs 5800 making a profit of Rs. 500 [(Spot price - Strike price) - Premium].
In another scenario, if at the time of expiry stock price falls below Rs. 5000 say suppose it touches Rs.4800, the buyer of the call option will choose not to exercise his option. In this case the investor loses the premium (Rs 300), paid which should be the profit earned by the seller of the call option.
Put Option:
A put option is the reverse of the call option. It gives the holder the right to sell an asset at a predetermined price. Investors bearish on the future trends of the asset price can use a put option. It confers the same benefits as in a call option.
Example: An investor buys one European Put option on Reliance at the strike price of Rs. 300/- , at a premium of Rs. 25/-. If the market price of Reliance, on the day of expiry is less than Rs. 300, the option can be exercised as it is 'in the money'. The investor's Break-even point is Rs. 275/ (Strike Price - premium paid) i.e., investor will earn profits if the market falls below 275. Suppose stock price is Rs. 260, the buyer of the Put option immediately buys Reliance share in the market @ Rs. 260/- & exercises his option selling the Reliance share at Rs 300 to the option writer thus making a net profit of Rs. 15 [(Strike price - Spot Price) - Premium paid].
In another scenario, if at the time of expiry, market price of Reliance is Rs 320/ -, the buyer of the Put option will choose not to exercise his option to sell as he can sell in the market at a higher rate. In this case the investor loses the premium paid (i.e. Rs 25/-), which shall be the profit earned by the seller of the Put option.
Europen Option & American Option
Option holder has the right to exercise his option but not the obligation. The question is when can he exercise his right. Should it be on the maturity date or can he exercise it at any time after he has entered the contract. If the option can be exercised on the maturity date only, then the option is a European option. In India all options that are being introduced are of the European type. The other type of option is known as the American Options. Most option contracts traded in developed markets are of the American type. The biggest advantage with the American Option is that it can be exercised by the holder at any point of time after entering the contract.
In-the-Money Options
Those options which are trading in positive territory are called in-the-money options. This means that in the event of exercising the option, it leads to a gain for the investor. For instance, in the example given above, if the stock was trading at Rs 5,500 on 31st March, 2003 then the option is in-the-money option from the point of view of the holder
Out-of-the-Money Options
Those options which give a negative cash flow to the investors are classified as out-of-the-money options. For instance, in the above example, if the price of INFOSYS on 32st March was Rs 4,500, then it would have generated a negative cash flow if exercised. Hence the option is classified as out-of-the-money.
At-the-Money Options
Those options which do not result in any cash flow, in other words, which result in zero cash flow for the investors are called At-the-money options. For instance, in the same example as described above is the price of INFOSYS was Rs 5,000 on 31st March, then the option is at-the-money option.
Leaps (Long Term Equity Anticipation Securities)
LEAPS or Long-term Equity Anticipation Securities are long-dated put and call options on common stocks or ADRs. These long-term options provide the holder the right to purchase, in case of a call, or sell, in case of a put, a specified number of stock shares at a pre-determined price up to the expiration date of the option, which can be three years in the future.
Exotic Options
Derivatives with more complicated payoffs than the standard European or American calls and puts are referred to as Exotic Options. Some of the examples of exotic options are as under: - Barrier Options: where the payoff depends on whether the underlying asset's price reaches a certain level during a certain period of time. CAPS traded on CBOE (traded on the S&P 100 & S&P 500) are examples of Barrier Options where the pay-out is capped so that it cannot exceed $30. A Call CAP is automatically exercised on a day when the index closes more than $30 above the strike price. A put CAP is automatically exercised on a day when the index closes more than $30 below the cap level. - Binary Options: are options with discontinuous payoffs. A simple example would be an option which pays off if price of an Infosys share ends up above the strike price of say Rs. 4000 & pays off nothing if it ends up below the strike.
Over the Counter Options
OTC ("over the counter") options are those dealt directly between counter-parties and are completely flexible & customized . There is some standardization for ease of trading in the busiest markets, but the precise details of each transaction are freely negotiable between buyer and seller.
