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Options Basics
What is an Option?
• An option is a contract to buy/sell a stock (underlyer).
• Contract defines a fixed price at which stocks would be traded. This is called
strike price.
• Contract has a maturity date which is the last date until the contract is valid.
• The seller sells the contract to Buyer.
• Buyer pays the price of the contract called premium to seller.
• Buyer has the right, but not the obligation to buy/sell the stock(underlyer) at a
fixed price (strike price).
• The contract also obligates the seller or writer to meet the terms of delivery if
the contract right is exercised by the contract buyer.
If you have not fully understood the concept of Option please don’t loose heart.
Continue to read the FAQ section; many of your doubles will get cleared after reading
subsequent sections.
What is a strike price?
It is the fixed price at which owner (buyer) of the CALL option can buy the underlying
asset from option seller, no matter whatever is the current price of the underlying asset.
Example, If strike price of Reliance CALL option is 1300 that means buyer of this
option can buy Reliance stock at 1300 even if the current market price of the stock is
higher (say 1500).
In case of Put options, strike price is the price at which owner (buyer) of the PUT
option can sell the underlying asset to the option seller, no matter whatever is the
current price of the underlying asset. Example, if strike price of Reliance PUT option is
1300 that means buyer of this option can sell Reliance stock at 1300 even if the current
market price of the stock is lower (say 1100).
What is a premium?
What is a lot size?
Options are traded in pre-defined lots. For example if you want to buy NIFTY options
you have to buy in lots. In case of NIFTY, 1 lot = 50 contracts. You can trade only
whole number contracts like 1, 2, 3 and so on but not in fractions.
What is options expiry?
Options expiry is a date after which the contract is no longer valid. Every contract has
a expiration date.
What is a call options?
A call is an option contract that gives the owner the right to buy the underlying stock at
a specified price (strike price) for a certain, fixed period of time (until its expiration).
What is a put option?
A call is an option contract that gives the owner the right to sell the underlying stock at
a specified price (strike price) for a certain, fixed period of time (until its expiration).
How to decide whether I should buy/sell call or Put options?
If you are bullish
• You may consider BUY-ing CALL options
• You may consider SELL-ing PUT options (remember that selling naked option
is a risky strategy and mostly used by expert traders)
If you are bearish
• You may consider BUY-ing PUT options
• You may consider SELL-ing CALL option
How can I benefit from buying a call option?
People buy CALL option when they are bullish i.e. they anticipate that price of the
underlying stock will move up.
Let’s understand using an example. Suppose, today’s date is 1-MAY-2008 and you buy
a RELIANCE CALL option (strike=2500, maturity June 2008) @ Rs. 50 per contract
when RELIANCE stock was getting traded at 2400. Let’s see what happens after
options expiration.
Case I : Reliance stock price greater than the strike price. Reliance stock trading at
2600 on expiry day cut-off time
Net profit = (current price – strike price) - premium = (2600 – 2500) -50= Rs. 50 per
contract
Case II : Reliance stock price less than strike price (2500) on expiry day cut-off time
Net loss = Premium paid = Rs. 50 per contract
So when you buy a CALL option you have unlimited profit potential but limited risk or
downside.
How can I benefit from buying Put option?
People buy PUT option when they are bearish i.e they anticipate that price of the
underlying stock will go down.
Let’s understand using an example. Suppose, today’s date is 1-MAY-2008 and you buy
a Reliance PUT option (strike=2500, maturity June 2008) @ Rs. 50 per contract when
RELIANCE stock was TRADING at 2600. Let’s see what happens after options
expiration.
Case I : Reliance stock price is less than the strike price. Reliance stock trading at
2400 on expiry day cut-off time
Case II : Reliance stock price >= strike price (2500) on expiry day cut-off time
Net loss = Premium paid = Rs 50 per contract
So, when you buy a PUT option you have unlimited profit potential but limited risk or
downside.
How can I benefit from selling a call option?
This is a bearish strategy. It has unlimited loss and limited profit potential. Selling
options is not recommended for beginner level traders.
Let’s understand it using an example. Suppose you want to SELL NIFTY call option
(strike=5000 expiration June 2008) on 1-MAY-2008 at 50 Rs per contract and NIFTY
was trading at 4900 at that time.
When you get a buyer for this contract you get paid @ Rs. 50 per contract and are
credited to your account. Let’s see what happens after options expiration.
Case I: NIFTY price <= strike price on expiry day cut-off time
Net Profit = 50 (Premium credited to your account when the trade was executed)
Case II : NIFTY price > strike price on expiry day cut-off time
Let’s understand it using an example. Support you SELL a NIFTY PUT option
(strike=5000, expiration June 2008) on 1-MAY-2008 at 50 Rs per contract when
NIFTY was trading at 5050.
When you get a buyer for this contract you get paid @ Rs. 50 per contract and are
credited to your account. Let’s see what happens after options expiration
Case I: NIFTY price >= strike price on expiry day cut-off time
Net Profit = 50 (Premium credited to your account when the trade was executed)
Case II: NIFTY price < strike price on expiry day cut-off time
If you own(bought) an European style option, you can exercise your right to buy (in
case of call options) or right to sell (in case of put options) underlying asset only on the
expiry date.
What is the difference between Stock and Index options?
The underlying asset covered by index options is not shares in a company, but rather,
an underlying Rupee value equal to the index level multiplied by Lot size. The amount
of cash received at upon exercise or expiration depends on the settlement value of the
index in comparison to the strike price of the index option.
In India Index options have EUROPEAN exercise style and Stock options are
AMERICAN exercise style. For more details refer question on difference between
EUROPEAN & AMERICAL exercise styles. For questions regarding option exercise
& exercise styles please refer OPTION EXERCISE section.
How can I find out if a particular option is American style or European style?
Refer www.nseindia.com. Under F&O section you can see contract information. If
Option type is CE means CALL European style option, CA means CALL American
style option, PE means PUT European style option, PA means PUT American style
option.
Are both American style and European style options available for trading in Indian
markets?
Yes. In NSE Index options are of European style whereas stock options are of
American style.
A Put option is in the money when its strike price is above the current market price of
the underlier (stock, Index etc.) . For example, if you bought a 5000 NIFTY PUT
OPTION and NIFTY is trading at 4900 the put option is in-the-money.
What are out-of-money options?
A call option is out-of-money when its strike price is above the current market price of
the underlier (stock) . For example, if you bought a 5000 NIFTY CALL OPTION and
NIFTY is trading at 4900 the call option is out of money.
A Put option is out-of-money when its strike price is below the current market price of
the underlier (stock) . For example, if you bought a 5000 NIFTY PUT OPTION and
NIFTY is trading at 5100 the put option is in-the-money.
What are at-the-money options?
An option is at-the-money if the strike price of the option equals (or nearly equals) the
market price of the underlying security(stock).
What is intrinsic value of the option?
Intrinsic value can be defined as the amount by which the strike price of an option is
in-the-money . Some people view it as the value that any given option would have if it
were exercised today
For Call options, Intrinsic value = Current Stock price – Strike Price
For Put Options, Intrinsic value = Strike Price - Current Stock price
Note intrinsic value cannot have negative value so minimum intrinsic value is 0 for an
option
What is time value of the option?
Time Value = Option Price - Intrinsic Value
If stock XYZ is trading at Rs 105 and the XYZ 100 call option is trading at Rs 7,
Intrinsic value = 105 – 100 = 5
Time Value = 7 – 5 = 2
Rise or fall in the open interest may be interpreted as an indicator of the future
expectations of the market. A rising open interest number indicates that the present
trend is likely to continue. If the open interest number is stagnant, then it may suggest
that the market is in a cautious mode.
If Open interest starts declining, then the market suggests a trend reversal mood. In a
rising market, continuous decline of open interest indicates an expectation of
downward movement. Similarly, in a falling market, the decline of open interest
indicates that the market expects an upward trend.
What is the difference between volume and open interest?
Volume is the number of contracts of a particular option contract that have traded on a
given day, similar to it meaning the number of shares traded on a particular stock on a
given day. Open interest is the number of option contracts for a particular stock at a
specific strike price and a specific expiration date that were open at the close of trading
on the prior trading day. While some traders look at this information as an indication of
liquidity of a particular option or option chain, a more reliable indicator may be the
tightness of the bid / ask spread.
A common misconception is that open interest is the same thing as volume of options
and futures trades. This is not correct, as demonstrated in the following example
-On January 1, A buys an option, which leaves an open interest and also creates trading
volume of 1.
-On January 2, C and D create trading volume of 5 and there are also five more options
left open.
-On January 3, A takes an offsetting position, open interest is reduced by 1 and trading
volume is 1.
-On January 4, E simply replaces C and open interest does not change, trading volume
increases by 5.
What does liquidity mean?
Ability of an option or other tradable security to get bought or sold in the market
without affecting the price.
What is PCR (PUT CALL RATIO)?
PCR is a very popular indicator to measure the prevailing level of bullishness or
bearishness in the market. Remember Put contract is bought by investors who are
bearish and Call contracts are bought by people who are bullish. PCR is calculated as:
As this ratio increases it means that investors are putting more money into put options
rather than call options. There are different ways you can interpret this information to
gauge market directions.
Delta value is used interpret the relationship between price movement of an option and
its underlyer stock/Index.
Who decides on the option price (premium)?
Like the stock trading price it is purely driven by Demand (buyers) and Supply
(sellers).
How could I know whether the price of a particular option is cheap or expensive?
You can compute the fair value of options using Binomial or Black Scholes formulas.
We do provide theoretical value of options in our web-site using Black-scholes model.
Exercising a stock PUT option means selling the stock at the price set by the option
(strike price), regardless of the stock's price at the time you exercise the option.
You may want to exercise your option when you want to take delivery of underlying
stock or Index.
Under what circumstances I should square off vs. exercise?
You may want to exercise if you want to take the delivery of underlying stock and you
have long/medium term interest in the stock. If you want to book profit or cut your
losses, you may want to close out your position by squaring off.
Can I exercise anytime or I need have to wait until the expiration day?
If the option is of American style then it can be exercised any day (when the market is
open) before its expiration. In case of European options it can be only exercised on the
expiration day.
I have taken a position on an European style option. We know European style options
can’t be exercised before expiry, so can’t I close my position before expiration day if I
want?
Yes, you can close out your position by squaring off which in short means taking the
reverse position.
If I exercise an in-the-money call option, how soon I can sell the underlying stock?
You can sell the underlying stock as soon as you give instructions to your broker to
exercise. We suggest you also double check with your broker if there are any
deviations and special rules apply.
If I am holding an option and its value has increased i.e. I am making profit right now,
Do I need to hold it until expiration? Will be a good move to book close out the
position and book profits?
It all depends on your outlook of stock and your risk/reward appetite. If you believe
that the stock has made its move to large extent and there is not much scope of further
movement in your anticipated direction then it you may want close out the position by
squaring off. On the other hand if you believe that there is lot more steam left and the
stock will go a long way, you can continue to hold your position.
What is options assignment?
When the holder (buyer) of options exercise the option writer(seller) is said to be
assigned the obligation to deliver the terms of option contract. If it is a CALL option
the writer(seller) needs to deliver the obligated quantity of the underlying security at
the strike price. In case of PUT option the writer(seller) needs to buy the obligated
quantity of the underlying security at the strike price.
Assignment is done on a random basis. The clearing house picks short positions that ae
eligible to be assigned and then allocates the exercised positions to any one or more
short positions.
What will happen if I have an open option position during options expiration day and I
have neither closed my position not excised?
All in the money options whether American or European style are automatically
exercised by the clearing house.
Can I revoke my order to exercise options?
No, once an order is accepted by clearing house it cannot be ordinarily revoked.
How do I know if I could get assigned (or exercised)? What is the likely hood of
getting assigned?
There is no way to know if you could get assigned. If you have sold an option there is
always a possibility of getting assigned on any business day before expiration (in case
the option is American style) to fulfill your obligation to receive (and pay for) or
deliver (and get paid for) shares of underlyer stock . There are some general rules that
you should keep in your mind:
Options Strategies
Both ‘Buy Call’ and “Sell Put” are bullish strategies. Which one should I choose?
‘Buy Call’ is capital gain strategy which involves uncapped profit potential and limited
loss, where as “Sell Call” is an income generation strategy which involves limited
profit and unlimited loss potential. Selling options are only recommended for
experienced investors.
Both ‘Buy Put” and “Sell Call” are bearish strategies. Which one should I choose?
‘Buy Put’ is capital gain strategy which involves uncapped profit potential and limited
loss, where as “Sell Put” is an income generation strategy which involves limited profit
and unlimited loss potential. Selling options are only recommended for experienced
investors.
I sold a call option and received a premium for that. If I get exercised do I need to give
back the premium to the buyer?
No, you keep the premium but you still need need to deliver the underlying stocks to
the options holder.
What are options spreads?
Options spreads are the basic building blocks of many options trading strategies. A
spread position is entered by buying and selling equal number of options of the same
class on the same underlying security but with different strike prices or expiration
dates. Refer our StrategyFinder tool to see real tradable strategies which also includes
spreads.
Can an individual person be both long and short the exact same option at the same
time?
If you do it from the same trading account it will offset each other. If you do it from
different accounts then you will have a flat position from economic perspective. There
is no visible advantage in doing so.
Margins
What is margin and why there is a need for it?
Margin is the amount of cash you need to deposit with your broker as a collateral if
you want to write an uncovered (naked) option. You also need to maintain margin to
cover your daily position valuation and reasonably foreseeable intra-day price changes.
When you short sell an option there is unlimited risk involved if the stock moves in
opposite of your expected market direction. There is always a possibility that the seller
will not be able to fulfill his obligation to deliver the terms of the contract due to lack
of funds. If the options price has increased significantly and the seller wants to close
out his position by buying out the option there is possibility that he may not have
sufficient funds in his account. This kind of situations will prevent markets from
functioning efficiently as the counter party wont be able to get his payement. To avoid
these kind of circumstances the concept of margins were introduced in all markets
across the world.
What is options volatility? Does change in volatility affect margins? If yes how?
Volatility is a measure of the rate and magnitude of the change of prices (whether up or
down) of the underlying. To put it simply you can view volatility as the speed at which
price of underlying can move in either direction. If volatility is high, the premium on
the option will be relatively high, and vice versa.
How can I find out how much margin is applicable for an options?
You can find out the applicable margin from your broker. Many online brokers like
www.hdfcsec.com , www.icicidirect.com etc. do provide tools to calculate margin
requirements.
Will I get margin benefits if I have positions on different underlying?
No, you will not get margin benefits in this case.
Will I get margin benefits if I have positions in both futures and options on same
underlying?
Yes, you will get benefits in this case.
Will I get margin benefit if I have counter positions in different months on same
underlying?
Yes, you will get margin benefits in this case. However, the benefit will be removed
three days prior to expiry if the near month contract.
Options Geeks
What is option DELTA?
Delta can be defined as amount by which an option’s price will change for
corresponding 1 point change in price of the underlying stock or index. Long Call
options have positive deltas, whereas Long put options have negative delta whereas
Short Call options have negative delta, and Short put options have positive delta. Let
understand using couple of examples.
• Delta of NIFTY Mar-2009 3000 CALL is 0.50. Theoretically, this means that if
NIFTY moves up by 1 point, this option’s price will go up by 0.5 point.
Similarly, if NIFTY moves down by 1 point, this options price will go down by
0.5 point
• Delta of NIFTY Mar-2009 2800 PUT is -0.75. Theoretically, this means that if
NIFTY moves up by 1 point, this option’s price will go down by 0.75 point.
Similarly, if NIFTY moves down by 1 point, this options price will go up by
0.75 point
Note that DELTA values are dynamic and changes almost everyday.
What is option GAMMA?
If Delta is viewed as the ‘speed’ of price movement of option relative to underlying
then option Gamma can be viewed as the acceleration. Basically, Gamma measures the
amount by which delta changes for a 1 point change in the stock price. For example, if
Gamma of an option is 0.5, that means theoretically that with 1 point price movement
of underlying the delta will move 0.5. Long calls and long puts have positive gamma
whereas short calls and short puts have negative gamma.
What is an option VEGA?
Vega can be interpreted as the amount by which the price of an option will change with
1% change in implied volatility of the underlying. One common scenario when option
Vega changes is when there is a large movement in underlying price. Long calls and
long puts both have positive vega where as short calls and short puts will always have
negative Vega.
What is an option THETA?
Option theta can be interpreted as change in the price of the option with one day
decrease in the remaining life of the option. To put is simply it is a measure of time
decay. Note that longer the life of an option, the higher will be the premium and vice
versa. With each passing day the value of option decreases (considering all factors
equal).
What is theoretical value of an option?
When you want to buy an option you probably want to know what is the fair value of
the option and what should be the fair price of an option, whether the option is under-
valued, over valued or rightly valued. You can get answers to these questions by
calculating the theoretical value of an option. There are many mathematical models
and formulas available which can be used.
What are Binomial and Black-holes equations?
These are mathematical models that can be used to calculate the theoretical value and
greeks of an options.
How important is it to use options geeks?
If you consider option Greeks in taking decisions to buy or sell options you are
basically increasing your probability to make a profit in your trades.