Introduction to Options

An option contract is the right, but not the obligation, to buy (in case of the call) or sell (in case of the put) a particular futures contract at a specific price (strike price) on or before certain expiration date.
Every investor must be familiar with the old adage of “Buy Low and Sell High” but with options you can make profits when the markets are going up, down or even sideways. So, it is very important for any new trader entering the options market to get familiar with all the different aspects of the options market and with wide concepts and terms more commonly used in options trading world. It may look a bit complicated in the beginning but as you becomes familiar with the different if `s and but`s of the options market, the trading will become very easy, enjoyable and surely very profitable.

There are two types of option contract: – Call Option & Put Option. You can buy or sell either type. Each offers an opportunity to take advantage of futures price moves without actually having a futures position.

 

Call Option

A call option is a right to buy or take a long position in a given asset at a fixed price on or before a specified date. In other words, a call option is an agreement between you and the seller where he agrees to sell you a specific stock or asset at a fixed price on or before an expiration date.
So, the buyer of the call option contract has the choice to buy the asset or let the agreement expires but it’s an obligation for the seller of the call option contract, if the buyer chooses to buy the asset.

Suppose, Mr. Srinivisan wants to buy a house (asset) for Rs. 50 Lacs (Fixed Price) from the seller who asks him to pay a privilege or premium amount of 1 Lac (Premium) to extend you a time period of 3 month (Expiration Date) to pay him. Then Srinivasan had the choice to either buy the house or let the agreement expires but the seller of the house had an obligation to sell the house, if Mr. Srinivasan chooses to buy the house, on or before the expiration time (i.e. 3 months).
Suppose, if at the end or before three month expiration, Srinivasan is able to find a buyer for that house for any price more than your agreed amount, say 60 Lacs, then he exercise his option to buy the house for Rs. 50 Lacs and make a profit of 9 Lacs (60 – 50 -1).
But on the other hand, if Srinivasan is unable to find a buyer for that house for more than 50 Lacs, then he lose 1 Lacs premium and he do not need to buy that house and let his right to buy expires.

Same applies with buying call options on index or stocks. For example, if you are expecting Nifty Index to rise from its current price of Rs. 7000 then you buys a Nifty 7000 call option for Rs. 50. Suppose if, before the expiration of the Contract, the price advanced to Rs. 7200 then the price of that 7000 call option will rise to 200+ and you can make a profit of Rs. 150.
On the other hand, if the price falls to say 6800, then you let your right to buy expires and you had your limited loss of Rs. 50.

 

Put Option

A put option is a right to sell or take a short position in a given asset at a fixed price on or before a specified date. So, the buyer of the put option contract has the choice to sell the asset or let the agreement expires but it’s an obligation for the seller of the put option contract.
For example, if you are expecting Nifty Index to fall from its current level of 7000, then you buy a Nifty 7000 put option for Rs. 50. Suppose if, before the expiration of the Contract, the price decline to 6800 then the price of that 7000 put option will rise to 200 and you can make a profit of Rs. 150.
On the other hand, if the price rises to say 7200, then you let your right to buy expires and you had your limited loss of Rs. 50.

 

Option Buying & Selling

If you buy an option (Call or Put), you have the right to buy/sell the underlying instrument at the strike price on or before expiration. The situation is different if you sell or write an option. Selling an option obligates the writer to fulfill their side of the contract if the option holder wishes to exercise.
However, just as the buyer can sell an option back into the market rather than exercising it, a writer can offset the options contract by purchasing an option to close the transaction and end their obligation.

The list below illustrates the rights and obligations of the Call Buyers & Sellers.

Call Buyers Call Sellers
Have right to buy the underlying Have an obligation to sell, if assigned
Pays premium Collects premium
No Margin requirement Incur Margin Requirement
Loss is limited to premium paid Loss could be unlimited
Profits can be unlimited Profits are limited to premium received
Time decay works against them Time decay works in their favor

The list below illustrates the rights and obligations of the Put Buyers & Sellers.

Put Buyers Put Sellers
Have right to sell the underlying Have an obligation to buy, if assigned
Pays premium Collects premium
No Margin requirement Incur Margin Requirement
Loss is limited to premium paid Loss could be unlimited
Profits can be unlimited Profits are limited to premium received
Time decay works against them Time decay works in their favor

 

Difference between a Futures Contract & Options Contract

Futures contract is an obligation for both the buyer and seller of the futures contract where the seller is obligated to deliver the asset and buyer is obligated to take the delivery of the asset under agreement while options agreement gives a choice to the buyer of the options contract and an obligation for the seller of the contract.

 

Key Concepts & Terms

Underlying Future Contract

The underlying is the corresponding futures contract that is purchased or sold upon the exercise of the option. For example, an option on a November Nifty futures contract is the right to buy or sell one Nifty Future contract. An option on BankNifty December futures gives the right to buy or sell one December BankNifty futures contract.

 

Contract Size

Each options contract has a standardized size that does not change. For Example, If you are trading index options the contract size of BankNifty and Nifty is always 25 units while every stock has a specific contract size.
At present in India, there are 6 Index Options, 135 stock options and 6 long term Nifty Options available for trading.

Contract size for Index & Stock options  (Download)

 

Exercise Price / Strike Price

Exercise price, also known as Strike Price, is the price at which the underlying will be delivered should the holder chooses to exercise his right to buy or sell.
For example, by buying a Nifty October 8000 Call Option, the buyer of the option is getting the right to buy Nifty futures contract at 8000. Similarly, the buyer of a Nifty October 8000 Put Option is getting the right to sell the Nifty Futures contract at 8000.

Strike prices are set by the Exchange and have different intervals depending on the underlying contract. Strike prices are set above and below the existing futures price and additional strikes are added if the futures move up or down.
For Example, Nifty Futures is currently trading at the level of approx. 8000 mark so the strike price available for Nifty options are from 6000 levels to 9500 with every 50 intervals i.e., 6000 Call & Put, 6050 call & put till 9500 call & put. So, by buying a 7900 Call Option, the buyer is getting the right to buy Nifty Futures at 7900.

 

Expiration Date

This is the last day on which the options contract can be exercised as after this day the contract ceases to exist i.e. the buyer cannot exercise the option and sellers have no obligations. All contracts except Long term Nifty option contracts expires last Thursday of every month.
For Example, Nifty October 8000 Call option will have the expiration on 30th October 2014, while Nifty Nov 8000 call will have expiration on 27th November, 2014.

 

Margin

An option buyer must only pay the total premium of the option contract to buy a call or a put but on the other hand, the option seller are required to deposit a margin to open and maintain a selling position in call or put option as option seller is prone for an unlimited loss, since there is no cap on how high a stock/asset price can rise. So, he is under obligation to pay a margin just like in case of futures contract.

Read Why More Margin is Required to Short / Write Options than Buying Options?

 

Premium

Premium is the total amount paid by the buyer of the options contract to get the right to buy or sell the underlying futures contract while it is the price received by the seller of the options contract. So, for any options buyer the risk is limited to the initial premium amount paid and for an options sellers the premium received is the maximum profit he can get by taking a position in the contract.
For example, by buying a Nifty October 8000 Call Option at a premium of Rs 150, the buyer of the option is getting the right to buy Nifty futures contract at 8000 for Rs. 150 while seller of the contract receive Rs. 150 to undertake the obligation. Similarly, the buyer of a Nifty October 8000 Put Option at Rs. 90 is getting the right to sell the Nifty Futures contract at 8000 for Rs. 90 while seller of the contract receive Rs. 90 for the obligation.
The price of the premium is dependent on a number of factors including strike price of the option, time remaining to expiration, market volatility, and interest rates.

An option’s premium has two main components: Intrinsic Value & Time Value
i.e., Options Premium = Intrinsic Value + Time Value

Intrinsic Value is the difference between the market price of the underlying & the options strike price.
Intrinsic Value (Calls) = Current Market Price – Strike Price
Intrinsic Value (Puts) = Strike Price – Current Market Price

For Example, if Nifty future is currently trading at the price level of 8000 and Nifty November 7800 call is trading at a premium of Rs. 305. If we are buying a 7800 call, we are buying the right to buy Nifty futures at 7800 when the current market price of Nifty is 8000. So, the actual real value of the contract is the intrinsic value i.e. Rs. 200 (8000-7800).

Time Value is any amount an investor is ready to pay for an option above its intrinsic value. This amount reflects the expectations of the market participants that the option’s value can increases before expiration due to a favorable change in the underlying security’s price. The longer the amount of time available for market conditions, the greater the time value.
Options sellers trading strategies rest around cashing in this time value.

In the above example, for Nifty November 7800 call option we paid a premium of 305 while the actual intrinsic value of the contract is Rs. 200, So the time value we are paying for the right we bought is Rs. 105 (305 -200).

 

Time Decay

The longer the time remaining to the contract expiration, the higher the price of the premium. This is because of the fact that the longer the time left, the greater the possibility of the price of the underlying can change and move favor. Time decay is a very important concept unavoidable for any options trader as the value of the option reduces with the passage of time and specially much faster during the last few days before expiry of the contract. So, any options buyer can lose the value of the premium even if market movement remains sideways during his course of trade. It works within the favor of the option sellers as more and more time passes on the time value of the option contract diminishes very rapidly.

 

Squaring the Position

Most of the option traders square their positions to book their profits or limit their losses prior to the expiration. Option buyers can offset their options position by selling their options (call or put) during the trading time before expiration date. Similarly, option sellers can square their “short” options position by buying their options (call or put).

 

In the Money, At the Money & Out of the Money

Strike price of an options contract in relation to the underlying market price determines whether the option is in-the-money, at-the-money or out-of-the-money.
For any call option, if the strike price is less than the market price it is said to be in the money, if the strike price is equal or closest to the market price it is said to be at the money and if the strike price is more than the market price it is said to be out of the money.
For any put option, if the strike price is more than the market price it is said to be in the money, if the strike price is equal or closest to the market price it is said to be at the money and if the strike price is less than the market price it is said to be out of the money.

Call Option Put Option
In-the-Money Strike Price < Market Price Strike Price > Market Price
At-the-Money Strike Price = Market Price Strike Price = Market Price
Out-the-Money Strike Price > Market Price Strike Price < Market Price

 

Why to Trade Options?

Hedging
To reduce your risk!

Today, many investors use the options market to manage the risk of their stock holding price fall. Suppose, an investor is holding stocks of Asian Paints Ltd and he is expecting a fall in the price of the stock but he is unwilling to sell his holding, he can buy a put option of Asian Paints which will give him a right to sell the stock at strike price at a cost of the premium paid.
So, any fall in the market price of the stock will be offset with the similar rise in the value of the put option. This is known as Hedging.

 

Knowledge is Power!

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Part VII – Getting Started With Trading – How to Trade Options?
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