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Options
 
  What is an Options Contract?
  What are the advantages of Options?
  How are Options different from Futures Contracts?
  How does an Option Contract get settled?
  What is the advantage of Exchange-traded Options?
  Who can write options in Indian Derivatives market?
  What is a Call Option?
  What is a Put Option?
  What are 'In the Money', 'At the Money' & 'Out of the money' Options?
  What are Covered & Naked Calls?
  What are Intrinsic Value and Time value of an option?
  What is Volatility with reference to Options?
  How is Option Premium calculated? Is it fixed by the Exchange?
  What are the risks for an Option buyer?
  What are the risks for an Option writer?
  How can an option writer take care of his risk?
 
What is an Options Contract?

An option is a financial derivative which represents a contract sold by one party (option writer) to another party (option holder). The contract offers the buyer the right, but not the obligation, to buy (call) or sell (put) a security or other financial asset at an agreed-upon price (the strike price) during a certain period of time or on a specific date (exercise date). On the other hand the seller of the option is under the obligation to perform the contract (buy or sell the underlying) for which he receives a payment called “premium” at the time of entering into the contract.

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What are the advantages of Options?

Options are extremely versatile securities that can be used in many different ways. Apart from offering the basic flexibility to the buyer in the form of right to buy or sell, they help both speculators and hedgers alike in the following ways:

Leverage – An option contract is a high leveraged product as by investing a small amount of capital (in the form of premium), one can take exposure in the underlying asset of much greater value.

Risk – The option buyer’s risk is pre-known and limited.

Profit Potential – The profit potential of the option buyer is unlimited with a loss potential limited to the extent of the premium.

Hedging Mechanism – Options can be used to protect oneself against adverse movement in market prices. For example, one can protect his equity portfolio from a decline in the market by way of buying a protective put wherein one buys puts against an existing stock position. Hence, by paying a relatively small premium (compared to the market value of the stock), an investor knows that no matter how far the stock drops, it can be sold at the strike price of the Put anytime until the Put expires.

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How are Options different from Futures Contracts?

Options are different from futures in several interesting senses. Some of these differences are listed below:

  • Right vs Obligation: In case of Futures contract, both the buyer and seller are obligated to buy/sell the underlying asset. In case of options contract, the buyer enjoys the right & not the obligation, to buy or sell the underlying asset.


  • Risk Profile: Futures Contracts have symmetric risk profile for both the buyer as well as the seller (with potential for huge losses on both sides), whereas options contracts have asymmetric risk profile. In case of Options, for a buyer (or holder of the option), the downside is limited to the premium (option price) he has paid while the profits may be unlimited. For a seller or writer of an option, however, the downside is unlimited while profits are limited to the premium he has received from the buyer.


  • Influencing Factors: The Futures contracts prices are affected mainly by the prices of the underlying asset. The prices of options are however; affected by prices of the underlying asset, time remaining for expiry of the contract, interest rate & volatility of the underlying asset.

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How does an Option Contract get settled?

An Option is a contract which has a market value like any other tradable commodity. Once an option is bought, there are the following alternatives:

  • Sell an option of the same series as bought and close out /square off position in that option at any time on or before its expiry date.


  • Exercise the option on the expiration date in case of European option or before the expiration date in case of an American option.


  • Positions that are “out of the money” at the time of expiry, will not be exercised for the obvious reason that they are not profitable. Therefore, such options will automatically lapse or expire worthless.

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What is the advantage of Exchange-traded Options?

The main advantage of Exchange traded Options is that buyers and sellers of options can off-set their positions before the expiry date in a similar way to off-setting futures contracts on exchanges. Option writers face unlimited risks, as they have to deliver or take delivery of the underlying instruments no matter what the circumstances.

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Who can write options in Indian Derivatives market?

As per SEBI regulations, any market participant can write options. However, the margin requirements are stringent for options writers, since they face unlimited risks.

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What is a Call Option?

A Call Option gives the holder (buyer/one who is long), the right to buy a specified quantity of the underlying asset at the strike price on or before expiration date in case of American option. The seller (one who has a short call) however, has the obligation to sell the underlying asset if the buyer of the call option decides to exercise his option to buy. The call option holder can make a profit if the underlying asset increases in price, but limits his loss to the cost of the option if the underlying asset loses value.

Example: An investor buys one European Call option on a stock ‘X’, having a strike price of Rs. 3000 at a premium of Rs. 50. On the date of expiry, if the market price of stock ‘X’ is greater than Rs. 3000, the call option buyer will exercise his option. His break even will happen when market price is Rs. 3050 (Strike Price + Premium, i.e. 3000 +50). Net Profit / Loss = {(Expected Market Price – Strike Price) – Premium}

Payoff from Call Option at different Expected Market Prices

Expected Market Price Strike Price Premium Net Profit/Loss Option Exercised
3200 3000 50 150 Yes
3050 3000 50 0 Yes
3020 3000 50 (30) Yes
3000 3000 50 (50) No
2800 3000 50 (50) No

Thus, the maximum loss incurred by call option buyer is equal to the premium (Rs. 50). On the other hand, for the seller of the call option, the maximum profit is Rs. 50, which is the premium. The loss potential of the option writer is unlimited and increases with increase in the market price of the stock.

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What is a Put Option?

A Put option gives the holder (buyer/ one who is long), the right to sell specified quantity of the underlying asset at the strike price on or before expiry date in case of American option. The seller of the put option (one who is short) however, has the obligation to buy the underlying asset at the strike price if the buyer decides to exercise his option to sell. The put option holder can make a profit if the price of the underlying asset decreases, but limits his loss to the cost of the option if the underlying asset gains value.

Example: An investor buys one European Put option on a stock ‘X’, having a strike price of Rs. 3000 at a premium of Rs. 50. On the date of expiry, if the market price of stock ‘X’ is lower than Rs. 3000, the put option buyer will exercise his option. His break even will happen when market price is Rs. 2950 (Strike Price - Premium, i.e. 3000 - 50). Net Profit / Loss = {(Strike Price – Expected Market Price) – premium}

Payoff from Put Option at different Expected Market Prices
Expected Market Price Strike Price Premium Net Profit/Loss Option Exercised
2800 3000 50 150 Yes
2950 3000 50 0 Yes
2980 3000 50 (30) Yes
3000 3000 50 (50) No
3200 3000 50 (50) No

Thus, the maximum loss incurred by put option buyer is equal to the premium (Rs. 50). On the other hand, for the seller of the put option, the maximum profit is Rs. 50, which is the premium. The loss potential of the option writer is unlimited and increases with decline in the market price of the stock.

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What are 'In the Money', 'At the Money' & 'Out of the money' Options?

An Option is In-the-Money when there would be profit exercising it immediately and Out-of-the-Money when it would be worthless if exercised immediately.

The option with the strike price closest to the prevailing market price of the underlying products is At-The-Money. This happens when the option's strike price is equal to the underlying asset price (for both puts and calls). The option payoff for calls and puts is summarized below:

 

CALL OPTIONS

PUT OPTIONS

In-the-money

Strike Price < Market Price of underlying asset

Strike Price > Market Price of underlying asset

At-the-money

Strike Price = Market Price of underlying asset

Strike Price = Market Price of underlying asset

Out-of the-money

Strike Price > Market Price of underlying asset

Strike Price < Market Price of underlying asset

 

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What are Covered & Naked Calls?

Writing covered calls involves writing call options with an existing opposite position in the underlying. This means that the shares that might have to be delivered (if option holder exercises his right to buy), are already owned by the call writer. 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). When a physical delivery uncovered/ naked call is assigned on 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 are Intrinsic Value and Time value of an option?

Option Premium consists of 2 parts - Intrinsic value and Time value.

Intrinsic value: 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. Intrinsic value is always positive or zero, but never negative.

Intrinsic value of a Call Option = Underlying asset price - Strike price

Intrinsic value of a Put Option = Strike price - Underlying asset price

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: 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. Generally longer the time to expiry, the higher the option's time value Time value cannot be negative.

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What is Volatility with reference to Options?

Volatility is a measure of the price movements of the underlying instrument of that option. Option prices increase as volatility rises and decrease as volatility falls. More the volatility of the underlying instrument, the greater the time value will be. The greater will be the uncertainty faced by the option seller, thereby resulting in a higher option premium.

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How is Option Premium calculated? Is it fixed by the Exchange?

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 & then depending on market conditions the price is determined by competitive bids & offers in the trading environment.

An option's premium / price is the sum of Intrinsic value & time value. 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 & to the immediate effect of supply & demand for both the underlying & its option.

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What are the risks for an Option 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?

While the gains of an Options Writer are limited to the premiums earned, his risk is unlimited. When an uncovered call is exercised for physical delivery, the call writer will have to purchase the underlying asset from the market 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. Theoretically, the price of the underlying asset can decline to zero. When put option holder exercises his option in the falling market, the put writer is bound to purchase the underlying at strike price, even if the underlying is otherwise available in the spot at lower price.

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How can an option writer take care of his risk?

The risk of being an option writer may be reduced by the purchase of other options on the same underlying asset and thereby assuming a spread position or by acquiring other types of hedging positions in the options/ futures and other correlated markets. Before entering into option writing, one must remember that option writing is a specialized job, which is suitable only for the knowledgeable investor who understands the risks, has the financial capacity and has sufficient liquid assets to meet applicable margin requirements.

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