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Introduction to Options

In this chapter, we will introduce the basis elements of an Option. We will cover things such as what is meant by an option, what are the two types of options, what is meant by strike price, option price, expiration date, etc. The objective of this chapter is to familiarize the reader with the basics of options.

Tejas Khoday
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In this module, we will talk in detail about one of the most versatile derivative instrument, Options. Over the course of the next several chapters, we will cover options in detail, starting right from the basics such as defining what an option is and the types of options before gradually proceeding to more complex areas such as Option Greeks and Option strategies. So, without any further delay, let us get started with the exciting world of options.

 

Options basics

Option defined

An option is a derivative contract that gives the holder of the instrument (i.e. the buyer) the right, but not an obligation, to buy or sell an underlying asset at a certain fixed price on or before a pre-determined date.

Let us now break this definition down into pieces:

- A right to the buyer, but not an obligation

- Buying or selling an asset at a fixed price

- Buying or selling an asset on or before a pre-determined date

 

Two types of Options

Before proceeding further, let us first talk about the two types of options: Call and Put

A Call option is an option that gives the buyer a right, but not an obligation, to buy an underlying asset at a certain fixed price on or before a pre-determined date.

A Put option is an option that gives the buyer a right, but not an obligation, to sell an underlying asset at a certain fixed price on or before a pre-determined date.

Notice the difference (highlighted in bold, underlined)? In case of a call option, the buyer has a right to buy an underlying asset; while in case of a put option, the buyer has a right to sell an underlying asset.

What about the option seller? Well, in case of a call option, the seller has an obligation to deliver the underlying asset to the call buyer, in case the call buyer exercises his right to buy the asset. Similarly, in case of a put option, the seller has an obligation to buy the underlying asset from the put buyer, in case the put buyer exercises his right to sell the asset.

 

Strike price (aka exercise price)

The pre-agreed price at which the asset will be exchanged on or before the pre-determined date is called the strike price or the exercise price.

 

Risk and reward potential

The buyer of an option has limited risk, while the seller of an option has unlimited risk. On the other hand, the buyer of an option has a potential for unlimited reward, while the seller of an option has a potential for limited reward.

 

Option price (aka Option premium)

As we have seen, the buyer has a right to exercise the option, and not an obligation. On the other hand, the seller has an obligation to honour the option, in case the buyer exercises his or her right to the option. Because the buyer has a privilege over the seller, the buyer must compensate for it by paying the seller a premium. This premium is nothing but the option price, which is also known as the option premium. Put it in other words, option price is the price that the buyer must pay to the seller to acquire the right to the option contract.

 

Expiration date

Earlier, when defining what an option is, we talked about the pre-determined date. This is nothing but the expiration date of an option. The buyer of an option can exercise his right to the option or close out the option position up to or on the expiration date. In case the buyer does not exercise his right to the option or close out the position up to or on the expiration date, the option expires worthless. In such a case when the option expires worthless, the seller gets to keep the entire premium.

 

View of an Option holder/writer

The buyer of a call option is bullish on the price of the underlying. He expects the price of the underlying to go up in the future. Hence, he buys a call option, which exposes him to limited risk and a potential for unlimited reward. To buy a call option, the buyer must pay an option premium.

The buyer of a put option is bearish on the price of the underlying. He expects the price of the underlying to decline in the future. Hence, he buys a put option, which exposes him to limited risk and a potential for unlimited reward. To buy a put option, the buyer must pay an option premium.

The seller of a call option is bearish on the price of the underlying. He expects the price of the underlying to either decline or be stable in the future. Selling a call option exposes him to unlimited risk for a potentially limited reward (the premium that he receives). One might wonder why would someone trade an instrument where the risk is unlimited, but the potential reward is limited? Well, one reason for this is that the seller would get to keep the option premium in case the buyer does not exercise the option. The other reason is that the odds are heavily stack against the option buyer making money. Notice that in order to profit, a call buyer would want the underlying price to go up, whereas a call seller would want the underlying price to either go down or remain stable. In other words, mathematically, we can see that the odds of a call buyer making money is just one-thirds, while that of a call seller making money is two-thirds.

The seller of a put option is bullish on the price of the underlying. He expects the price of the underlying to either rise or be stable in the future. Selling a put option exposes him to unlimited risk for a potentially limited reward (the premium that he receives).

 

A simple example

Now that we have understood the basic elements of an option, let us take a simple example to apply these concepts. Let us assume that a stock is currently trading at ₹100. Let us assume that Mr. A believes the stock will rise to ₹110 in a month’s time, while Mr. B feels that the stock will be at or below ₹100 over the same period. Given their respective views, let us assume that the two decide to trade a call option on this stock having a strike price of, say,₹100. In other words, this is the price at which Mr. A (the call option buyer) will have the right to buy the stock from Mr. B (the call option seller) in a month’s time. To do so however, Mr. A will have to pay a premium to Mr. B, which is nothing but the option price. Let us say that the price of this option is ₹5. One month down the line, one of the three things could occur: the price of the stock could go up, down, or remain essentially the same.

If the price of the stock has gone up to, say, ₹110, the buyer will exercise his right to buy at the pre-determined price (the strike price) of ₹100. In other words, the buyer will be able to buy at a price that is below the prevailing market price of ₹110. Also, as the buyer has exercised his right to buy at ₹100, the seller will be obliged to sell the stock at ₹100. As such, the buyer would make a gain of ₹10 (₹110 market price - ₹100 strike price). Reducing the premium of ₹5 that the buyer has already paid, the buyer’s total gain would be ₹5. On the other hand, the seller would suffer a loss of ₹10 (₹100 strike price - ₹110 market price). Reducing the premium of ₹5 that the seller has received, the seller’s total loss would be ₹5.

Meanwhile, if the price of the stock has gone down to, say, ₹95, the buyer will not exercise his right to buy at the pre-determined price of ₹100 as he can directly buy it from the market at a lower price of ₹95. Hence, the buyer will let the option expire worthless. As such, the buyer would lose the entire premium of ₹5, which will be his loss. On the other hand, as the buyer has not exercised his right to the option, the seller will get to keep the entire premium of ₹5 with him, which is his profit.

Let us now put everything that we have learned so far in a tabular format:

 

Call Option Put Option
Definition A call optiongivesthe holder a right to buy an asset at a certain price on or before a pre-determined future date A put option gives the holder a right to sell an asset at a certain price on or before a pre-determined future date
Buyer A call buyer has a right, but not an obligation, to buy the asset at a certain price on or before a pre-determined future date A put buyer has a right, but not an obligation, to sell the asset at a certain price on or before a pre-determined future date
Seller A call seller has an obligation to give delivery of the asset to the call buyer at a certain price on or before a pre-determined future date, in case the call buyer exercises his right to the option A put seller has an obligation to take delivery of the asset from the put buyer at a certain price on or before a pre-determined future date, in case the put buyer exercises his right to the option
Buyer’sother names Holder or owner
Seller’sother names Writer
Risk to buyer Limited to the extent of premium paid
Risk to seller Potentially unlimited
Reward to buyer Potentially unlimited
Reward to seller Limited to the extent of premium received
Buyer’s view Bullish Bearish
Seller’s view Bearish Bullish

As a small exercise, let us present a few examples to gain further clarity on understanding the concept of ‘’exercising the option”. As the right to exercise the option lies with the buyer, the below examples are presented from a buyer’s perspective.

Option Type

Call
Option Price ₹3.00
Strike Price ₹100.00
Underlying price at initiation ₹95.00
Underlying price in 1-month ₹108.00
Will the Buyer exercise? Yes
Why? By exercising the option, the buyer can buy the underlying at ₹100, when it is available in the market for ₹108, enabling him to gain ₹8 (as he is able to buy at a price that is below the market price)
Profit/loss? Profit of ₹5 after reducing the cost (option price of ₹3)

 

Option Type Call
Option Price ₹3.00
Strike Price ₹100.00
Underlying price at initiation ₹95.00
Underlying price in 1-month ₹93.00
Will the Buyer exercise? No
Why? As the underlying price in a month’s time is lower than the strike price of ₹100, the buyer will not exercise his right to buy, as he can directly buy the underlying from the market at ₹93
Profit/loss? Loss of ₹3 as the buyer has not exercised his right to buy

 

Option Type Put
Option Price ₹4.00
Strike Price ₹100.00
Underlying price at initiation ₹103.00
Underlying price in 1-month ₹90.00
Will the Buyer exercise? Yes
Why? By exercising the option, the buyer can sell the underlying at ₹100, when it is available in the market for ₹90, enabling him to gain ₹10 (as he is able to sell at a price that is above the market price)
Profit/loss? Profit of ₹6 after reducing the cost (option price of ₹4)

 

Option Type Put
Option Price ₹4.00
Strike Price ₹100.00
Underlying price at initiation ₹103.00
Underlying price in 1-month ₹107.00
Will the Buyer exercise? No
Why? As the underlying price in a month’s time is higher than the strike price of ₹100, the buyer will not exercise his right to sell, as he can directly sell the underlying in the market at ₹107
Profit/loss? Loss of ₹4 as the buyer has not exercised his right to sell
 
 

Option exercising style: American vs. European

There are two types of options: American and European. An American option is a type of option that can be exercised at any time up to the expiry of the contract. In other words, if the option contract is American, the buyer of such an option contract could exercise his right to buy (in case of a call) or sell (in case of a put) at any time until the expiration of the contract. On the other hand, a European option is a type of option that can only be exercised on the expiry of the contract. In other words, if the option contract is European, the buyer of such an option contract can exercise his right to buy or sell only on the expiration of the contract.

Most of the other features of options are essentially the same. It is only the exercising style that separates the American option from the European option. Because an American option can be exercised at any time up to the expiry of the contract whereas a European option can be exercised only on expiration, American options are more valuable (i.e. expensive) than their European counterparts. To understand why this is the case, think about it for a while from a seller’s perspective. In case the seller has written an American option, the buyer could exercise it at any time up to the expiry. For instance, if the buyer buys an Out-of-the-Money American call option that has two months left to expiration and if that option moves In-the-Money tomorrow, the buyer could decide to exercise it the moment it moves In-then-Money, which in turn would oblige the seller to sell the underlying to the buyer at a price that is below the market price. Such an exercise, however, won’t be possible with a European option. Hence, as the seller has a greater risk of an American-style option being exercised at any time up to expiration, to compensate for this risk, American options would be more valuable than European options. In other words, American options would have a higher option premium that their corresponding European contracts.

All options that are traded on Indian exchanges are European options, meaning the buyer of options in India can exercise his right only on the day of the expiry and not on any other day.

 

Concluding with some basic terminology learned in the chapter

Now that we have a strong understanding of the basics of options, it is time to conclude this topic by discussing about the terminologies that we have learned so far. The concepts that we have learned in this chapter would form the basic blocks of things that we are going to discuss in the forthcoming chapters, including Option Greeks and Option Strategies. Hence, it is crucial to have a strong understanding of these terminologies. We advise a reader to spend quality time on understanding theterminologies that we have discussed in this chapter, before moving ahead to the next chapter.

  • Call option:A call option gives the buyer the right to buythe underlying asset in the future for a specific price, called the strike price.

  • Put option:A put option gives the buyer the right to sellthe underlyingasset in the future for a specific price, called the strike price.

  • Long position:A long position implies buyingan option, which could be a call or a put or both.

  • Short position:A short position implies sellingan option, which could be a call or a put or both.

  • Strike price:Strike price refers to a pre-agreed price at which the underlying asset will be bought (in case of call option) or sold (in case of put option) on or beforethe expiration day. It is a price that is specified at the time of entering into an option contract. It is also known as the exercise price.

  • Underlying price: This refers to the current price of the underlying instrument. At any point in time, the current or the underlying price of a security could be above the strike price of that underlying, or below the strike price, or exactly at the strike price.

  • American Option: An American option is an option that can be exercised at any time up to the expiry of the option contract.

  • European Option: A European option is an option that can be exercised only on the expiry day of the option contract.

Next Chapter

Option Price and Option Moneyness

5 Lessons

In this chapter, we shall study some crucial concepts that pertain to options. These include the two elements of option price (intrinsic value and time value) and moneyness of an Option. We will also cover how to calculate the breakeven point of an option, how to calculate the profit/loss potential of an option and discuss about the option payoff charts. We will conclude this chapter by talking about the key terminologies that were covered over the course of this chapter.

Factors that impact Option Price

7 Lessons

Now that we have a good understanding about the basic elements of an Option, it is time to dig in a little deeper. In this chapter, we will talk about the seven factors that impact the price of an option. Gaining a good understand about these factors is the first step towards understanding how option prices move.

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fasil commented on January 23rd, 2020 at 8:58 PM  
At last, I understand what is an option. Thanks to the simplified example


Shriram commented on January 23rd, 2020 at 9:57 PM  
Thank you Fasil! Hope you find the forthcoming Options chapters beneficial


matin commented on January 23rd, 2020 at 11:15 PM  
Provide in Hindi language. Also


Shriram commented on January 26th, 2020 at 4:58 PM  
Hi Matin, at present, we are focusing on content that is in English language, given that it is earlier and more effective to explain various technical terminologies in English to a wider range of audience.


Ankush commented on January 24th, 2020 at 5:29 PM  
excellent table wise explanation for call and put options. Thanks for making it simple. Keep it up good work


Shriram commented on January 26th, 2020 at 5:00 PM  
Thank your Ankush for your valuable feedback. Hope you find the other chapters and modules beneficial!


Shivprasad Verma commented on January 27th, 2020 at 7:24 PM  
I like in the way you have explain option in a simple terms, good work please carry on.


Shriram commented on January 27th, 2020 at 8:46 PM  
Thank you for the feedback Shivprasad!


shrikant commented on February 19th, 2020 at 8:36 PM  
Dear sir,
Please provide the only Hindi language


Arun commented on February 20th, 2020 at 7:04 AM  
I dont understand Hindi. Y u want o ly hindi


rajiv commented on March 17th, 2020 at 2:56 AM  
can you provide it it pdf format show that i do not have to sit on computer and read


Shriram commented on March 18th, 2020 at 6:47 PM  
Hi Rajiv, at present, we have the modules only on our website


Sivakumar Menon commented on May 26th, 2020 at 8:48 PM  
A very easy to understand Basics of Call &Put Options. Good work


Shriram commented on May 28th, 2020 at 9:03 PM  
Hi Sivakumar, thank you for the valuable feedback!


Vinayak commented on June 10th, 2020 at 6:53 PM  
I think I read on BSE ot NSE site that in India stock options are American style and Index options are European style.


Abhishek Chinchalkar commented on June 12th, 2020 at 8:25 AM  
Hi Vinayak, stock options that are traded on the NSE and BSE are European style options, which can be exercised only at expiration and not before that. You can check this out on the NSE/BSE website too.

Meanwhile, a quick way to identify the style of an option is to check its symbol. If it CE or PE, it means it is European where CE stands for Call European style and PE stands for Put European style.


Vinayak commented on June 12th, 2020 at 1:52 PM  
Thank you Abhishek. Are the Index options also European style in India because the same nomenclature seems to be followed for NIFTY option? Btw.. I learned what does E in CE and PE means now :-). Thank you!


Abhishek Chinchalkar commented on June 12th, 2020 at 3:06 PM  
Yes Vinayak, index options traded on our exchanges are also European style options. They cannot be exercised before expiration.


Vinayak commented on June 12th, 2020 at 6:39 PM  
I have two doubts related to how much I need to pay or how much do I receive when buying or selling an option contract.

Consider an option of premium Rs. 2 and lot size is 100.
(1) When I buy 5 lots of the above option do I need to pay 5x2=10 rupees or 5x100=500 rupees?
(2) When I sell 5 lots of the above option do I receive 5x2=10 rupees or 5x100=100 rupees? And when do I get this money if I don't intend to sqaure off the position?


Abhishek Chinchalkar commented on June 13th, 2020 at 11:54 AM  
Hi Vinayak, let me show this using the example you presented:

1). When buying an option, you need to make 100% upfront payment. This value can be calculated as option premium * lot size * number of lots purchased. So the answer is 2 * 100 * 5 = 1000. So, to buy 5 lots, you will have to pay Rs.1000 upfront.
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2). When selling an option, the premium that you will receive is also calculated using the same formula i.e. option premium * lot size * number of lots sold. So again, this turns out to be Rs.1000.

However, because an option seller is exposed to unlimited risk, he/she will have to deposit a certain amount upfront in his/her trading account as margin, which usually varies between 20-30% of the total contract value for carrying overnight short positions.

The total contract value can be roughly calculated as (strike + premium) * lot size * number of lots sold. In your example, let us assume the strike price as 100. So, the total contract value is approximately (100 + 2)*100*5 = 51000. Assuming a 25% margin, you need to have at least 12750 in your trading account (25% of 51000) to sell 5 lots of options.

So, when you sell 5 options, 12750 will be blocked from you account and 1000 will be credited into your account, bringing down the net blocked amount to 11750.

When you close you short position, the blocked amount of 12750 will be released. Simultaneously, the balance premium amount (because you are buying back the option) would be debited. For instance, let us say that the option premium has declined to Rs. 1.5 and now you want to exit your position. So, 12750 will be unblocked and because you are closing out your short position, Rs. 750 will be debited from your account (1.5*100*5).

So, net-net, you can see that you made a gain of Rs. 250 from your trade (premium credited at start 1000 - premium debited at end 750). You can also think of this logically. You sold the option at 2 and bought it back it as 1.5, leaving you with a profit of 0.5 per option for a total profit of 250 (0.5*100*5).


Vinayak commented on June 14th, 2020 at 12:40 PM  
Abhishek, thank you so much for the very detailed answer to my question. I got all the answers except for one which is: when do I get this money if I don't intend to square off the position. Basically, my question is, in case of short position what happens if I don't square off the position at all? Does it go in some sort of auction similar to I think the way it goes in case of stocks?


Abhishek Chinchalkar commented on June 15th, 2020 at 7:37 PM  
Hi Vinayak, index futures and options continue to be cash settled. Physical delivery is applicable to stock futures and options only. Because there is no delivery-related obligation in index futures and options, the concept of auction does not apply to index.


Vinayak commented on June 16th, 2020 at 11:55 AM
Okay. So what I understood is when I don't square off the position taken, in case of index futures and options it will be cash settled and in case of stocks I will have to give or take delivery. Right?


krish commented on June 16th, 2020 at 7:21 PM
in the above example ..if the option sold belongs to equity segment and the option strike expired as OTM option and we havent squared off on the expiry day...can we retain the rs 1000/- we received and no need for delivery of shares since its expired as otm option...


Karthik commented on June 16th, 2020 at 4:47 PM  
Hi , if I'm selling nifty 10300 ce option and spot expired at 9900 and I didn't square off my position at expiry do I need to pay any charges? Can I leave options to expiry if its otm when I'm selling?


Abhishek Chinchalkar commented on June 18th, 2020 at 6:00 PM  
Hi Karthik, because the option is OTM, it will expire worthless and you as a seller will get to retain the premium that you had received upfront. Also, as NSE index options are cash settled, there won't be any penalty in case the position is not closed out before expiration.


rakesh roshan commented on June 21st, 2020 at 10:47 AM  
hi Sir,

thank you very much very clear and crisp explanation.

Thanks/Rgds


Abhishek Chinchalkar commented on June 22nd, 2020 at 7:28 AM  
Hi Rakesh, thank you for the valuable feedback!


Deepak commented on September 3rd, 2020 at 1:56 PM  
Hi Abishek,

I see many doing intraday bank nifty options trading. They buy it and sell it on the same day, sometimes even in minutes. But, I read above, that for European style we can sell it only on the expiry day?
Can you please comment and help me understand, how this works.

Thanks & Regards
Deepak


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