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Chapter 2.5:What is Options Trading?
What are Options?
An ‘Option’ is a type of security that can be bought or sold at a specified price within a specified period of time, in exchange for a non-refundable upfront deposit. An options contract offers the buyer the right to buy, not the obligation to buy at the specified price or date. Options are a type of derivative product.
The right to sell a security is called a ‘Put Option’, while the right to buy is called the ‘Call Option’.
They can be used as:
- Leverage: Options help you profit from changes in share prices without putting down the full price of the share. You get control over the shares without buying them outright.
- Hedging : They can also be used to protect yourself from fluctuations in the price of a share and letting you buy or sell the shares at a pre-determined price for a specified period of time.
Though they have their advantages, trading in options is more complex than trading in regular shares. It calls for a good understanding of trading and investment practices as well as constant monitoring of market fluctuations to protect against losses.
Just as futures contracts minimize risks for buyers by setting a pre-determined future price for an underlying asset, options contracts do the same however, without the obligation to buy that exists in a futures contract.
The seller of an options contract is called the ‘options writer’. Unlike the buyer in an options contract, the seller has no rights and must sell the assets at the agreed price if the buyer chooses to execute the options contract on or before the agreed date, in exchange for an upfront payment from the buyer.
There is no physical exchange of documents at the time of entering into an options contract. The transactions are merely recorded in the stock exchange through which they are routed.
When you are trading in the derivatives segment, you will come across many terms that may seem alien. Here are some Options-related jargons you should know about.
- Premium: The upfront payment made by the buyer to the seller to enjoy the privileges of an option contract.
- Strike Price / Exercise Price: The pre-decided price at which the asset can be bought or sold.
Strike Price Intervals: These are the different strike prices at which an options contract can be traded. These are determined by the exchange on which the assets are traded.
There are typically at least 11 strike prices declared for every type of option in a given month - 5 prices above the spot price, 5prices below the spot price and one price equivalent to the spot price.
Following strike parameter is currently applicable for options contracts on all individual securities in NSE Derivative segment:
The strike price interval would be:
|No. of Strikes Provided
In the money-
At the money- Out of the money
|No. of additional strikes which
may be enabled intraday in
|Less than or equal to Rs.50||2.5||5-1-5||5|
|> Rs.50 to = Rs.100||5||5-1-5||5|
|> Rs.100 to = Rs.250||10||5-1-5||5|
|> Rs.250 to = Rs.500||20||5-1-5||5|
|> Rs.500 to = Rs.1000||20||10-1-10||10|
Strike Price Intervals for Nifty Index
The number of contracts provided in options on index is based on the range in previous day’s closing value of the underlying index and applicable as per the following table:
|Index Level||Strike Interval||Scheme of Strike to be introduced|
|>2001 upto 4000||100||6-1-6|
|>4001 upto 6000||100||6-1-6|
- Expiration Date:
A future date on or before which the options contract can be executed. Options contracts have three different durations you can pick from:
- Near month (1 month)
- Middle Month (2 months)
- Far Month (3 months)
*Please note that long terms options are available for Nifty index. Futures & Options contracts typically expire on the last Thursday of the respective months, post which they are considered void.
American and European Options:
The terms ‘American’ and ‘European’ refer to the type of underlying asset in an options contract and when it can be executed. American options’ are Options that can be executed at any time on or before their expiration date. ‘European options’ are Options that can only be executed on the expiration date.
Please note that in Indian market only European type of options are available for trading.
Lot size refers to a fixed number of units of the underlying asset that form part of a single F&O contract. The standard lot size is different for each stock and is decided by the exchange on which the stock is traded.
E.g. options contracts for Reliance Industries have a lot size of 250 shares per contract.
Open Interest refers to the total number of outstanding positions on a particular options contract across all participants in the market at any given point of time. Open Interest becomes nil past the expiration date for a particular contract.
Let us understand with an example:
If trader A buys 100 Nifty options from trader B where, both traders A and B are entering the market for the first time, the open interest would be 100 futures or two contract.
The next day, Trader A sells her contract to Trader C. This does not change the open interest, as a reduction in A’s open position is offset by an increase in C’s open position for this particular asset.
Now, if trader A buys 100 more Nifty Futures from another trader D, the open interest in the Nifty Futures contract would become 200 futures or 4contracts.
Types of Options
As described earlier, options are of two types, the ‘Call Option’ and the ‘Put Option’.
The ‘Call Option’ gives the holder of the option the right to buy a particular asset at the strike price on or before the expiration date in return for a premium paid upfront to the seller. Call options usually become more valuable as the value of the underlying asset increases. Call options are abbreviated as ‘C’ in online quotes.
The Put Option gives the holder the right to sell a particular asset at the strike price anytime on or before the expiration date in return for a premium paid up front. Since you can sell a stock at any given point of time, if the spot price of a stock falls during the contract period, the holder is protected from this fall in price by the strike price that is pre-set. This explains why put options become more valuable when the price of the underlying stock falls.
Similarly, if the price of the stock rises during the contract period, the seller only loses the premium amount and does not suffer a loss of the entire price of the asset. Put options are abbreviated as ‘P’ in online quotes.
Understanding Options contracts with examples:
This means, under this contract, Rajesh has the rights to buy one lot of 100 Infosys shares at Rs 3000 per share any time between now and the month of May. He paid a premium of Rs 250 per share. He thus pays a total amount of Rs 25,000 to enjoy this right to sell.
Now, suppose the share price of Infosys rises over Rs 3,000 to Rs 3200, Rajesh can consider exercising the option and buying at Rs 3,000 per share. He would be saving Rs 200 per share; this can be considered a tentative profit. However, he still makes a notional net loss of Rs 50 per share once you take the premium amount into consideration. For this reason, Rajesh may choose to actually exercise the option once the share price crosses Rs 3,250 levels. Otherwise, he can choose to let the option expire without being exercised.
Rajesh believes that the shares of Company X are currently overpriced and bets on them falling in the next few months. Since he wants to secure his position, he takes a put option on the shares of Company X.
Here are the quotes for Stock X:
|February (Current month)||Rs 1040 Spot||NA|
|May||Rs 1050 Put||Rs 10|
|May||Rs 1070 Put||Rs 30|
Rajesh buys 1000 shares of Company X Put at a strike price of 1070 and pays
Rs 30 per share as premium. His total premium paid is Rs 30,000.
If the spot price for Company X falls below the Put option Rajesh bought, say to Rs 1020; Rajesh can safeguard his money by choosing to sell the put option. He will make Rs 50 per share (Rs 1070 minus Rs 1020) on the trade, making a net profit of Rs 20,000 (Rs 50 x 1000 shares – Rs 30,000 paid as premium).
Alternately, if the spot price for Company X rises higher than the Put option, say Rs 1080; he would be at a loss if he decided to exercise the put option at Rs 1070. So, he will choose, in this case, to not exercise the put option. In the process, he only loses Rs 30,000 – the premium amount; this is much lower than if he had exercised his option.
How are Options contracts priced?
We saw that options can be bought for an underlying asset at a fraction of the actual price of the asset in the spot market by paying an upfront premium. The amount paid as a premium to the seller is the price of entering an options contract.
To understand how this premium amount is arrived at, we first need to understand some basic terms like In-The-Money, Out-Of-The-Money and At-The-Money.
Let’s take a look as you may be faced with any one of these scenarios while trading in options:
- In-the-money: You will profit by exercising the option.
- Out-of-the-money: You will make no money by exercising the option.
- At-the-money: A no-profit, no-loss scenario if you choose to exercise the option.
A Call Option is ‘In-the-money’ when the spot price of the asset is higher than the strike price. Conversely, a Put Option is ‘In-the-money’ when the spot price of the asset is lower than the strike price.
How is Premium Pricing arrived at :
The price of an Option Premium is controlled by two factors – intrinsic value and time value of the option.
- Intrinsic Value
Intrinsic Value is the difference between the cash market spot price and the strike price of an option. It can either be positive (if you are in-the-money) or zero (if you are either at-the-money or out-of-the-money). An asset cannot have negative Intrinsic Value.
- Time Value basically puts a premium on the time left to exercise an options contract. This means if the time left between the current date and the expiration date of Contract A is longer than that of Contract B, Contract A has higher Time Value.
This is because contracts with longer expiration periods give the holder more flexibility on when to exercise their option. This longer time window lowers the risk for the contract holder and prevents them from landing in a tight spot.
At the beginning of a contract period, the time value of the contract is high. If the option remains in-the-money, the option price for it will be high. If the option goes out-of-money or stays at-the-money this affects its intrinsic value, which becomes zero. In such a case, only the time value of the contract is considered and the option price goes down.
As the expiration date of the contract approaches, the time value of the contract falls, negatively affecting the option price.
In this section, we understood the basics of Options contracts. In the next part, we go into details about Call options and Put options. Click here
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- Snapshot of profit/loss
- Reflects performance of your portfolio
- Helps compute taxes
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