Options are contracts, which gives the 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
commodities like wheat/ rice/ cotton/ gold/ oil or financial
instruments like equity stocks/ stock index/ bonds etc.
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How are options different from futures?
| The significant differences in Futures and Options are as under : |
Futures are agreements/contracts to buy or sell
specified quantity of the underlying assets at a price agreed upon by
the buyer and seller, on or before a specified time. Both the buyer and
seller are obligated to buy/sell the underlying asset. In case of
options the buyer enjoys the right but not the obligation, to buy or
sell the underlying asset. |
All Futures contracts have to be settled on the
contract date. Options contracts can be settled on or before the
settlement date depending on whether they are “American” style or
“European” style contracts |
Futures contracts prices are affected mainly by
the prices of the underlying asset. Prices of options are however,
affected by prices of the underlying asset, time remaining for expiry
of the contract and volatility of the underlying asset. |
| It costs nothing to enter into a futures contract whereas there is a cost of buying an options contract, termed as Premium. |
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What are European and American Style of options?
Options come in two varieties
– European vs. American. In a European option, the holder of the option
can only exercise his right (if he should so desire) on the expiration
date. In an American option, he can exercise this right anytime between
purchase date and the expiration date.
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What are Call Options?
A call option
gives the holder (buyer/ one who is long call), the right to buy
specified quantity of the underlying asset at the strike price on or
before expiration date.
The seller, however, has the
obligation to sell the underlying asset if the buyer of the call option
decides to exercise his option to buy.
Example : An
investor buys One European call option on Infosys at the strike price
of Rs. 3500 at a premium of Rs. 100. If the market price of Infosys on
the day of expiry is more than Rs. 3500, the option will be exercised.
The investor will earn profits once the share price crosses Rs. 3600 (Strike Price + Premium i.e. 3500+100).
Suppose
the stock price is Rs. 3800, the option will be exercised and the
investor will buy 1 share of Infosys from the seller of the option at
Rs 3500 and sell it in the market at Rs 3800 making a profit of Rs. 200
{ (Spot price – Strike price) – Premium}.
In another scenario,
if at the time of expiry, the stock price falls below Rs. 3500 say
suppose it touches Rs. 3000, the buyer of the call option will choose
not to exercise his option. In this case the buyer loses the premium
(Rs 100), paid which shall be the profit earned by the seller of the
call option.
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What are Put Options?
A Put option
gives the holder (buyer/ one who is long Put), the right to sell
specified quantity of the underlying asset at the strike price on or
before the expiry date.
The seller of the put option (one who
is short Put) however, has the obligation to buy the underlying asset
at the strike price if the buyer decides to exercise his option to
sell.
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.
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What is meant by the term Underlying
The
Underlying is the specific security / asset on which an options
contract is based. In case of an Index option, the index (Sensex /
Nifty) is the Underlying. In case of an option on Infosys, the Infosys
scrip becomes the underlying.
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What does Option Premium mean?
It is
the price paid by the buyer to acquire the right. This is the amount,
which the buyer of the option (whether it is a call or put option) has
to pay to the option writer to induce him to accept the risk associated
with the contract. In other words it is the price paid to buy the
option.
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What is the Strike Price or Exercise Price?
The strike price is the price at which the call / put option is written. This price is fixed by the Exchange currently.
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Explain what is meant by Expiration date?
An option contract has a finite life. The date on which the option expires is known as Expiration Date.
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Who is an Option Holder?
An 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.
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Who is an Option seller/ writer?
An
Option Writer is the one who is obligated to buy (in case of Put
option) or to sell (in case of call option), the underlying asset in
case the buyer of the option decides to exercise his option.
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What is meant by the term Assignment?
When
the 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.
What is meant by In the Money, At the Money and Out of the money Options.
An
option is said to be ‘at-the-money’, when the option’s strike price is
equal to the underlying asset price in the spot market. This is true
for both puts and calls.
A call option is said to be
in-the-money when the strike price of the option is less than the
underlying asset price. For example, a Nifty call option with strike of
1100 is ‘in-the-money’, when the spot Nifty is at 1200 as the call
option has value.
The call holder has the right to buy a Nifty
at 1100, no matter how much the spot market price has risen. And with
the current price at 1200, a profit can be made by selling the Nifty at
this higher price.
On the other hand, a call option is
out-of-the-money when the strike price is greater than the underlying
asset price. Using the earlier example of the Nifty call option, if the
Nifty falls to 1000, the call option no longer has positive exercise
value. The call holder will not exercise the option to buy Nifty at
1100 when the current price is at 1000.
A put option is
in-the-money when the strike price of the option is greater than the
spot price of the underlying asset. For example, a Sensex put at strike
of 4400 is in-the-money when the Sensex is at 4100. When this is the
case, the put option has value because the put holder can sell the
Sensex at 4400, an amount greater than the current Sensex of 4100.
Likewise,
a put option is out-of-the-money when the strike price is less than the
spot price of underlying asset. In the above example, the buyer of
Sensex put option won’t exercise the option when the spot is at 4800.
The put no longer has positive exercise value.
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Options are said to be deep in-the-money (or
deep out-of-the-money) if the exercise price is at significant variance
with the underlying asset price.
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What are Covered and Naked Calls?
An
option contract is said to be a Covered Call Option, when the option is
covered or protected by the writer by depositing the shares of the
company on which the option is written in an escrow account with the
brokerage firm. Therefore the writer of the call option does not have
to deposit any cash as such and whenever and exercise notice is
received from the clearing corporation, the shares are delivered. In
case, the option expires or if the writer enters into an offsetting
transaction, he can withdraw the stocks deposited.
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.
If a call option is written without owning the
underlying stock, it is called as Naked Call writing. When the writer
does not own the underlying stock, he has to deposit the necessary
amount of margin with the brokerage firm who in turn deposits it with
the exchange. However in such a case the cash margin to be deposited to
be 100% covered cannot be estimated as the upside movement is
unlimited.
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.
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What is the 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.
For a call option : Intrinsic Value = Spot Price – Strike Price
For a put option : Intrinsic Value = Strike Price – Spot Price
The
intrinsic value of an option must be a positive number or 0. It cannot
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.
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What is 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.
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What are the factors that affect the value of an option (premium)?
There are two types of factors that affect the value of the option premium :
Quantifiable Factors :
| Price of the underlying instrument. |
| Strike price. |
| Time remaining till expiration. |
| Risk-free interest rate. |
| Expected volatility. |
| Corporate action like dividend or interest payments, if any. |
Non-Quantifiable Factors :
| Market participants’ varying estimates of the underlying asset’s future volatility |
| Individuals’ varying estimates of future performance of the underlying asset |
| Supply & demand- both in the options marketplace and in the market for the underlying asset |
| “Depth” of the market for that option – the number of transactions and the contract’s trading volume on any given day. |
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Who decides on the premium paid on options & how is it calculated?
Options
Premium is not fixed by the Exchange. The fair value/ theoretical price
of an option can be known with the help of pricing models and then
depending on market conditions the price is determined by competitive
bids and offers in the trading environment.
An option’s premium /
price is the sum of Intrinsic value and time value (explained above).
If the price of the underlying stock is held constant, the intrinsic
value portion of an option premium will remain constant as well.
Therefore, any change in the price of the option will be entirely due to a change in the option’s time value.
The
time value component of the option premium can change in response to a
change in the volatility of the underlying, the time to expiry,
interest rate fluctuations, dividend payments and to the immediate
effect of supply and demand for both the underlying and its option.
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How do options trade get settled?
An
option is a contract which has a market value like any other tradable
commodity. Once an option is bought there are following alternatives
that an option holder has :
You can sell an option of the same series as the
one you had bought and close out /square off your position in that
option at any time on or before the expiration. |
You can exercise the option on the expiration day
in case of European Option or; on or before the expiration day in case
of an American option. In case the option is ‘Out of Money’ at the time
of expiry, it will expire worthless. |
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What are the risks involved for an options buyer?
The risk/ loss of an option buyer is limited to the premium that he has paid.
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What are the risks for an Option writer?
The
risk of an Options Writer is unlimited where his gains are limited to
the Premiums earned. When a physical delivery uncovered call is
exercised upon, the writer will have to purchase the underlying asset
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.
The writer of a put option bears a risk of loss if the value of
the underlying asset declines below the exercise price. The writer of a
put bears the risk of a decline in the price of the underlying asset
potentially to zero.
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How can an option writer mitigate his risk?
The
risk of being an option writer may be reduced by the purchase of other
options on the same underlying asset thereby assuming a spread position
or by acquiring other types of hedging positions in the options/
futures and other correlated markets.
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Who can write options in Indian derivatives market?
In
the Indian Derivatives market, any market participant can write
options. Sebi has not created any particular category of options
writers.
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What are Index Options?
The Index
Options are options where the underlying asset is a Stock Index for
e.g. Options on NSE Nifty/ Options on BSE Sensex etc.
As
opposed to options on Individual stocks, index options give an investor
the right to buy or sell the value of an index which represents group
of stocks.
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What are the uses of Index Options?
Index
options enable investors to gain exposure to a broad market, with one
trading decision and frequently with one transaction. To obtain the
same level of diversification using individual stocks or individual
equity options, numerous decisions and trades would be necessary.
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Who would use index options?
Index
Options are effective enough to appeal to a broad spectrum of users,
from conservative individual investors to more aggressive stock market
traders.
Individual investors might wish to capitalize on
market opinions (bullish, bearish or neutral) by acting on their views
of the broad market or one of its many sectors.
To a market
professional, managing risks associated with large equity positions may
mean using index options to either reduce risk or increase market
exposure.
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What are Options on individual stocks?
Options contracts where the underlying asset is an equity stock, are termed as Options on stocks. |